Is a Rate Cut Too Late To Prevent The Looming Recession?

The greenback traded at unprecedented levels last week losing some signficant ground against the majors and hitting an all time low against the EUR. The USD has been under pressure ever since the US housing bubble burst, this fact combined with the resulting spreading global credit crisis and the Feds hesitance to cut the interest rate has put the greenback on a very slippery slope. On Tuesday the Fed will release its much awaited interest statement and it is expected to cut the rate from 5.25 % to 5.00 %. The big question on investors minds now is if it is a too late to prevent the looming recession. All the recent economic data of employment and housing have all indicated that the US economy is slowing and that the threat of recession is now very real. The Fed has always maintained the stance that the subprime crisis will not spill over into the rest of the economy and that a rate cut is unnecessary as there is slow but moderate growth so the economy will eventually correct itself, however the recent economic data has indicated otherwise. Usually a reduction in a countries interest rate has a negative effect on its currency because it will eventually lower the level of foreign investment that is flowing into the country. However the US market seems to be operating in contradiction to economic theory as a rate cut by the Fed will provide the greenback with some reprieve. The reason for this is because the rate cut will boost the equity markets, albeit temporarily, and will it help ease the global credit crisis. Therefore these factors will encourage foreign investment and investors will still be pulled to the US economy although they will be receiving a lower yield.

The Feds hesitancy to take this action early on has now left the US economy on the tip of the recession iceberg and a rate cut on Tuesday by 25 basis points may have little effect. The main reasons why it is now strongly believed that the US economy will be unable to avoid a recession is because on last week Thursday the Fed cut the overnight rate to 5.09 % and this has had very little effect on the LIBOR (London Inter-Bank Offer Rate), which is where corporate credit is priced. Also according to traditional economic theory a change in monetary policy takes at least six months before it begins to exercise its full impact on the economy, therefore a rut cut now may be just a little too late. These factors leave the US economy in a precarious situation but nevertheless a 25 basis point reduction and dovish statement by the Fed on Tuesday will most likely give a temporary boost to equity markets but on the basis of historical data and similar past situations in the US economy this may still not be enough to prevent a recession.