Rate cuts: its unique characteristics

Investors were surprised by the bold strike of the Fed to slash the key interest rates by half a point, even though it was widely expecting the inevitable cuts amid the financial turmoil. Equally important, it is rare to see such a dramatic change in policymakers' stance between two FOMC meetings. In its August 7 meeting, Fed officials kept rates unchanged at 5.25% in spite of rising subprime defaults, reiterating its primary concern was still inflation that failed to moderate. But only ten days later, the Fed took an unusual step to cut the discount rate by 50bp between its scheduled meetings in view of the rapidly deteriorating financial market conditions. Still, the measure was more of a transitional nature than actual easing. Ironically, securitizations of subprime mortgages make it much harder for investors and lenders to judge how the risks were distributed. The Fed's role as a lender of last resort failed to restore normalcy to the panicking market. A worldwide credit crunch was in shape, cutting off bank loans and commercial paper financings. The Fed was compelled to lower its benchmark interest rates eventually. Such a rapid turnaround in its monetary policy bias is unusual, but the responsive move amid abruptly tight financial conditions is deemed positive.

From the last time the Fed raised rates to this first rate cut, interest rates remained unchanged for fifteen months, just shy of the record eighteen months registered during the 1997-1998 period. Officials cut rates by the same amount of 50bp in face of the technology bubble burst on January 3, 2001, which was greater than the 25bp initial reduction taken on September 29, 1998 to alleviate the LTCM crisis. The Fed's surprisingly strong move this time signals that the rate cut cycle is aimed at forestalling an economic recession as well as stabilizing the financial markets.

Unlike the previous rate cut cycles of 1998 and 2001, the Fed cuts its funds rates before the real economy is seriously affected by the credit crunch. Such cuts are preemptive. In 1998, the Fed started its long-awaited easing aimed at preventing the spread of the Asia Financial Crisis, Russia's debt default and the ensuing LTCM crisis even though the U.S economic outlook remained sanguine. The GDP in the third quarter of 1998 when the Fed started easing gained 4.7% and then posted another strong gain of 6.2% in the following quarter. However, the story in 2001 was entirely different. The US economy contracted by 0.5% in the third quarter of 2000, and registered another 0.5% decline in the first quarter of 2001. The Fed's easing move was intended to salvage growth. But at hind side, it was widely thought to have come too late to prevent the US economy from sliding into recession. In contrast, this time the Fed trimmed the fed fund target rate when the US economy grew at a brisk pace of 0.6% and 4.0% during the first two quarters of this year. The preemptive policy stance results in the central bank intervening at an early stage of an economic slowdown, which proves to be positive to both the financial markets and the real economy.

How can rate cuts help?

As for the question whether rate cuts could eventually solve the subprime problems, it is believed that any policy measures will have to address two issues simultaneously, the first of which is to stop the crisis from further deteriorating and the second to stabilizing the root problem of the US property market. In order to achieve the first objective, policy responses must be preemptive and responsive, and the magnitude of cuts must be sufficient.

Before rate cuts, the subprime meltdown continued. The delinquency rate in subprime mortgages surged to a five-year high of 14.82%. Even though the delinquency rate has been remaining high for years, its rapid rate of deterioration was alarming. Currently, the adjustable rate mortgages account for slightly more than 10% of the total mortgage loans in the US, whereas ARMs account for more than 70% of subprime mortgages. The market estimates that about $500 billion ARMs will reset their interest rates this year, and another $700 billion to reset by the end of 2008, with the subprime loans accounting for half of them. Subprime borrowers' interest payments will shoot up substantially as most borrowers enjoyed teaser rates in the first few years of origination. Those teaser rates could be as low as 1-3% in the first two years, whilst the average 30-year fixed rate mortgage hits 6.29% as of now. Thus their interest expenses could more than double after resets. Needless to say, delinquency and foreclosure will rapidly deteriorate under this vicious cycle.

Interest rate cuts and recovery of investors' confidence could help allay worries about rate resets. However, rate cuts may not be the perfect solution for the subprime problems. First of all, interest rate resets are ongoing and will peak in the coming one to two years. Meanwhile, the chances of the inflation–cautious central bank lowering rates by more than 200bp by the end of next year are limited. Even interest rate futures have not yet priced in such a result. Secondly, home prices and collateral values fall amid the subprime crisis. Commercial banks or mortgage lenders become more risk adverse in their lending practices. Therefore, cuts in official target rate may not be fully passed on to the mortgage rates for retail customers. Thus, if rate cuts are assisted by measures such as loan reorganizations by the lenders and government guarantees, they should help avert the subprime crisis.

With regard to stabilizing the property market, it will take some time for rate cuts to work. This is due to the fact that the US property market is not only under cyclical but also structural correction pressures. There will be a time lag for rate cuts to work. According to the data from the US Government, the average home prices in the US have not posted any year-over-year decline during the past 30 years, the corrections in the housing market were only reflected in the narrowing of price gains. Home prices gained by double digits for seventh consecutive quarters between 2004 and 2006 in spite of consecutive rate hikes, demonstrating the lagging effects of rate decisions. In the same manner, there will be a time-lag between the Fed's current rate cuts and the bottoming in the housing market. History tells us that substantial rate cuts would likely begin to show effects of halting the property slump in the second half of next year at the earliest.

To summarize, the focus of monetary easing is currently on preventing the spread of subprime panics. Its effects can be maximized in combination with regulatory guidance and other fiscal policies. It is expected that the housing sector will remain a drag on the world's largest economy due to the lagging effects of rate reductions.

Side effects and other considerations

An interest rate cut is a double-edged sword that could entail prices such as moral hazard and inflation risk. In this case, the moral hazard issue is that the Fed could bail out speculative players including lenders, borrowers and investors who engaged in risky financial decisions and overcommitted themselves. Rate cuts may embolden investors to take on even more debt and drive asset prices higher, planting the seeds for future bubbles.

Engaging in aggressive rate cuts without sufficient considerations for consequences could cause new and/or even greater uncertainties to future financial orders. Yet measures that can both starve off the current crisis and avoid moral hazard do not seem to exist, and a hard decision has to be made. The US Federal Reserve Chairman Ben Bernanke said earlier last month that it is neither the central bank's responsibility, nor is it appropriate to protect lenders and investors from their own financial decisions. But as the risk of an economic recession is heightened due to the subprime fallout, the Fed could not stand on the sideline given that maintaining sustainable growth being one of its policy mandates.

The downside risk to the US economy has increased notably in recent months, paving the way for the policymakers to cut rates. As there are no concrete answers to how subprime risks are diversified using securitizations and derivatives, who bear the risks, and how big the damage may be, panicking investors may dump assets and trigger credit crunch on a global scale. Banks shut down lines of credit regardless of the borrowers' creditworthiness amid upheavals in the credit market. Given that maintaining sustainable growth is one of its policy mandates, the Fed will almost certainly be obliged to cut rates to starve off a recession.

Thus, the Fed acted promptly and firmly, even though it is well aware of the potential pitfalls. In contrast, Bank of England has taken a more dovish stance on the subprime fallout and remains reluctant to inject liquidity into the banking system until the Northern Rock crisis. Northern Rock is the fifth largest mortgage lender in the UK which faced panic withdrawals due to credit crunch. BoE gets caught in a dilemma between preventing moral hazard and maintaining market orders. Should moral hazard remain a priority, depositors will come to a natural conclusion that the financial institution will not receive any rescue from the central bank. And bank runs appear to be the only outcome, resulting in a self fulfilling prophecy. In this case, the central bank also fails to exercise proper supervision to maintain market orders. After all, BoE's belated intervention has put its credibility on the line. Therefore, striking a balance between preventing moral hazard and acting to limit the potential adverse effects would be crucial for policy makers in the new era.

As such, improving regulations would help make amends to moral hazard prevention. Steps could be taken to work out more stringent rules governing subprime loans. Predatory practices of lenders must be tackled head on. And supervisions of the securitization process and further issuances of derivatives will have to be improved to bring transparency to how risks are diversified, who bears them and what damages could be, in order to avert confidence crisis and credit crunch. However, there has been little progress in supervising leveraged investment by non-bank financial institutions for years, and regulatory reforms still have a long way to go.

Inflation risks always come with accommodative monetary policy which should never be neglected. The Federal Reserve cut rates to forestall a US economic recession while accepting higher short term inflation as a trade-off. But the Fed still retains its inflationary bias and stated "some inflation risks remain" in the latest FOMC statement. Once the credit crunch passes, the Fed could quickly reverse course on interest rates if inflation pressure picks up. In the past, the Fed reversed to rate hikes only seven months after the three consecutive rate cuts during the LTCM crisis in 1998 when the core CPI rose modestly at 2.1% at that time. Nowadays, inflation stays stubbornly above the Fed's comfort zone, with both core CPI and core PCE hitting 2.1%. The core inflation leaves little room for the Fed to ease monetary policy further. Once economic indicators show that the economy has regained its footing, the Fed may shift its focus back to inflation fighting.

Dai Daohua
Senior Economist