Ben raises interest in rate cuts

Wiggins, Rogers, Prof Williams and Daisy are engaged in an animated conversation in their college corridor over US Fed Chief Ben Bernanke’s decision to lower interest rates for the second time in quick succession.

Wiggins begins the conversation inquiringly: “Why is there so much euphoria over Bernanke’s decision to lower interest rates? Why is everybody keenly watching what he is doing?”

Rogers answers nonchalantly: “It’s simple, he is trying to ward off recession.”

Daisy, a bit unsure about what the term means, asks: “First, tell me what is the difference between recession and depression?”

“Yup, there is a widespread misconception that recession and depression are the same. Actually they are not. Depression means a major slowdown in the economy that lasts more than a year. Whereas, recession means two consecutive quarters of negative growth that may even last several months, after which the economy is expected to revive,” Wiggins looks at Prof Williams for his approval.

Daisy gets more curious: “Okay, how can interest rates help ward off a slowdown in the economy?”

“Bernanke is trying to raise stock prices by lowering risk premiums. Lower risk premiums cause consumers to trim their precautionary savings, which, in turn, leads to more spending by households. The increased spending gets amplified through the Keynesian multiplier and kick-starts the economic activity, which remains subdued till now,” Prof Williams turns towards Daisy, “Is that clear?” he asks.

Helicopter money


Rogers appears unconvinced by Prof Williams’ reply, who goes on, “For instance, in 2001, the Fed aggressively lowered the rate target from 6.5 per cent in December 2000 to 1.75 per cent by December 2001, but that doesn’t seem to have revived the fortunes of the economy.”

“You are right. That is why many economists don’t buy the logic that lowering rates would improve the fortunes of the US economy. It all depends on how one looks at it,” Prof Williams goes on to explain, “Bernanke thinks that helicopter money can save the economy from falling into recession.”

“Professor, I am very sorry to interrupt you, what did you say ‘helicopter money’?” Wiggins asks.

“Yes, Fed chiefs believe that lower interest rates and tax cuts would drop cash in the hands of consumers, as if from a helicopter. On the other hand, economists have been arguing that lower interest rates have wider ramifications. The lower interest rate has resulted in cheap long-term mortgage as housing became affordable for many. Economists also feel that the interest rates are kept deliberately low, that is, below the inflation rate. A lot of consumers have taken loans at low interest and, once the Fed raises its rates, there will be more defaults.

“Once the bubble bursts, people might realise that too many houses were built too soon and the expected demand is not there, as there cannot be an endless new demand for new houses. This problem will worsen for those who buy property at artificially high prices, encouraged by lower interest rates. They will find the going tough when the interest rate rises along with the fall in the buying power of the dollar,” Prof Williams said, concluding his mini lecture on interest rates.

“Prof, If I have understood it right, the Fed chiefs are expecting the lower interest rates to help the companies to expand, but the whole thing is resulting in credit-based spending without any real productivity, right?” Rogers asks.

“Exactly,” Prof Williams continues, “If the Fed continues to lend at below inflation rates, it stands to lose money, thereby affecting the economy too in the process. Housing and mortgage will be the first victims.”

Arbitrage opportunity


Wiggins becomes restless, “How can somebody lend below the inflation rate? It’s like somebody selling a product below its cost price?”

“That’s right, it is similar to how we calculate real interest rates. When we deposit money in the bank, our real interest rate is arrived at by reducing the inflation rate from the interest rate offered by the bank.

“That is, if our deposits earn 10 per cent and if the inflation is at 5 per cent, it means our money in the bank earns only 5 per cent. In the same way, if the Fed lends at 3 per cent, when the consumer price index is at, say, 4.2 per cent, the Fed will lose 1.2 per cent for every dollar that it lends.

“Moreover, when interest rates are low, people in the US try to take advantage of the interest rate arbitrage and try to invest in countries such as India, where their money earns more interest. So the dollar flows out of the US to developing countries, where they get handsome returns for their money,” Prof Williams looks at the others and asks, “Is that clear?”

The three students nod their heads in unison and reply: “Yes, we even read reports that the dollar inflow into India has been causing a lot of headaches for those people, rendering their exports less competitive as the dollar has depreciated against the rupee.”

“So, now you know why everybody is watching the Fed’s moves very closely?” Prof Williams concludes with a smile.