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Stock market euphoria after U.S. rate cut financial scene

On September 18, the U.S. Federal Reserve lowered its overnight federal funds rate by 0.50 percentage point to 4.75 per cent. The significance of this action, the first in four years, was not lost sight of by investors. Most market participants were expecting a rate cut. But the actual size, which is twice what many were hoping for, seems to mark a major shift in policy and an abrupt reversal of course.

For consumers, the latest Fed action will lower borrowing costs on a variety of loans including mortgages and auto loans. The expectation that more money with consumers will push demand for a variety of products. It may not be a coincidence that the general liquidity crunch in the U.S. has affected many industries. Car sales have been dipping along with a steep fall in housing demand. Simultaneously, the Fed has lowered the discount rate by an identical margin. The new rate is 5.25 per cent. The discount rate is the rate at which banks borrow from the Fed and until August this year was hardly used.

Just six weeks ago, the Fed was forecasting modest growth for the U.S. economy and, in a stance familiar to those in India tracking the RBI, cautioning that inflation remained a significant threat. These signals should have called for monetary tightening or at best maintaining status quo. The aggressive rate cut came out of a realisation that the housing crisis as well as the larger problems in the credit markets were spinning out of control and were bound to affect the real economy sooner than anticipated.

However, neither the problems that the latest Fed action seeks to address nor the means adopted to solve them, are as clear cut as they would appear. Already there have been indications that the problems emanating from the twin crises — the mortgage crisis and the housing crisis — could drag the economy into a recession .An unchanged rate or even a moderate cut, say by 0.25 percentage point, may not be enough at this juncture. On the other hand, a hasty reduction in benchmark rates may result in inflation.

This kind of dilemma is often faced by the RBI too. Its two traditional monetary policy objectives are economic growth and price stability. The emphasis keeps shifting from one to the other.

At the moment, having tightened its monetary stance, the RBI is still concerned about inflation. Whether the U.S. action in signalling lower interest rates will be a trend setter remains to be seen but that is how the stock markets everywhere seem to be thinking.

There is another dilemma that the U.S. Fed faced. By cutting rates, is the central bank baling out those who took unacceptable risks, such as property speculators who were betting that prices would keep going up? The Fed Chairman was against such a course of action but ultimately gave in. Along with a possible economic downturn; total chaos in the financial markets was within the realm of possibility. In the mortgage market, for instance, none except the most creditworthy could raise loans.

The biggest ever gain in the Indian stock index, Sensex, last Wednesday — by 653 .63 points or 4.17 per cent — as also the sharp jump in the Nifty and in the benchmark indices of many other stock exchanges are attributed to the Fed action. Indian stock markets, like many of their Asian counterparts, were expected to gain but the magnitude of the rise was astounding. Various explanations have been given for what seems to be another bout of irrational exuberance. Over the week, the Sensex gained 6.4 per cent and the Nifty 7.3 per cent.

Here are some of the likely spinoffs from the Fed action. One, the U.S. economy should recover driven by a revival in consumption demand. The problems of the housing sector may not disappear but the participants including those who were reckless have now been given a chance to come out of the crisis. As a result countries dependent on the U.S. economy will benefit. For India too that should be good news. But the degree of linkages between India and the U.S., through becoming more pronounced, is nowhere near the levels that obtain between the U.S. and East Asian countries including China.

Two, lower interest rates in the U.S. should widen the interest differentials across the globe. More overseas capital will therefore flow towards India.

This argument is simplistic and ignores other parameters such as credit risks, country risks and so on that guide decisions of large investors. There is no evidence to conclude that the FIIs which invested heavily in Indian stocks on Wednesday were guided solely by the Fed action.

Three, the most plausible explanation for the stock market boom has to do with India’s economic growth story which remains dynamic. For foreign fund managers as well as domestic investors, opportunities are expanding in India.

Bust much as one would like to see a connection between the Sensex (and the Nifty) levels and GDP growth, it is naïve to stretch it too far. A Sensex, holding well above 16564 on Friday, does not give any indication whatsoever that Indian economic growth will be in double digits.

C. R. L. NARASIMHAN

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