Federal Reserve Board Chairman Alan Greenspan is the world's leading central banker. This is not onl...
Federal Reserve Board Chairman Alan Greenspan is the world's leading central banker. This is not only because he is the head of the central bank in the world's leading economy, but also because he has established a considerable reputation over many years, built on his skill and daring in setting monetary policy. His decision to cut 0.5% off US interest rates in the first week of the year certainly took the world by surprise.
Mounting evidence that growth in US economic activity is slowing sharply is being reflected elsewhere around the world. With the oil price now at more than $12 a barrel, lower than the ten-year peak reached late last summer, inflationary fears have reduced considerably.
An eventual cut in interest rates was expected, reversing the trend of the past year and more. But it was not expected until the end of January at the very earliest, or possibly until March, at one of the next two regular meetings of the Fed.
The decision to cut a half-point, rather than a quarter-point, off rates outside the usual cycle of meetings, signals a surprising degree of urgency in Greenspan's reversal of policy, and a commitment to a soft landing for the US economy.
It would now seem that investors can look forward to a series of interest rate cuts, making for a large overall easing of monetary policy over the remaining months of this year. At the same time, President-elect Bush looks almost certain to initiate substantial cuts in taxation.
The prompt action by the US policy makers now makes a soft landing rather more likely. Furthermore, the Fed's lead is likely to be followed by central bankers elsewhere, allowing interest rates to come down more rapidly than expected across the globe.
Previously, the main risk to the economic system was that persistently high oil prices and policy inertia might lead to a serious delay in cutting interest rates, producing at least a brief recession. Both of these fears have now dissipated.
The new direction that US interest rate policy has taken underwrites the recent sharp fall in bond yields, which have fallen by a full percentage point in just two months. Indeed, yields could continue to move lower if the cuts in interest rates are adequate, while economic growth eventually takes many months to recover as monetary policy is eased.
Equity markets, too, will be able to benefit from lower rates. Although the growth in earnings per share is likely to be generally poor in the very near term, the risk of a serious recession is now very much reduced.
When the Fed switched to a policy of monetary easing in the wake of the Russian debt crisis, the equity market rally was sharp. Share prices may rise similarly this year, as P/E ratios rise in sympathy with lower interest rates and bond yields, even while earnings growth remains poor.
Nigel Morgan is economic strategist at Old Mutual
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