Federal Reserve & Interest Rates

Federal Reserve Chairman Ben Bernanke gave an overview on Monday, on the impact of the financial crisis on Asia’s largest economies and it’s policy responses.  The growth in global trade allowed the financial crisis which began it this country to transmit it’s effects to the rest of the world, and Asian economies were hit hard but aggressive policy actions by many of those countries appears to have paid off.

In September and October 2008, as you know, the global financial crisis intensified dramatically.  Concerted international action prevented a global financial meltdown, but the effects of the crisis on asset prices, credit availability, and consumer and business confidence resulted in sharp declines in demand and production worldwide.  Reflecting this worsening economic climate, Asian GDP growth slowed further in the second half of 2008. 

For the region as a whole, the economic contraction in the fourth quarter of 2008 was pronounced, with activity falling at an annual rate of nearly 7 percent.  The fourth-quarter declines were especially dramatic in Taiwan and Thailand (more than 20 percent at an annual rate) and in South Korea and Singapore (more than 15 percent at an annual rate).  Among the major Asian economies, only those of China, India, and Indonesia did not contract during the crisis.

For most Asian countries, the severe drop off in global trade as well as disruptions in international capital flows played a large factor in the recessions of those countries.  However, low inflation levels allowed most of those countries to take aggressive stimulus actions and their economies appear to be on the brink of recovery.

Large trade and capital flow imbalances helped transmit financial instability to their economies and Bernanke points out that efforts need to be taken in the future to prevent this.  The United States need to increase it’s national savings rate but the large federal deficits expected over the next decade may make this difficult, on the flip side, Asian countries could reduce their overall savings rate by promoting domestic consumption, which may also prove difficult.

The lessons learned from the financial crisis has proved that global economies must take cooperative fiscal and monetary policy measures which are mutually beneficial.

The U.S. budget is expected to run a deficit of about $1.8 trillion for the fiscal year that ends in September.  Even before adding in the estimated costs of the proposed healthcare reform bill making it’s way through Congress, the next couple of years will also likely see trillion dollar deficits as well.

Although inflation isn’t a concern for the time being, a lot of people are watching out for it in the corner of their eye.  Noted investment guru Warren Buffet also raised concerns about the long term risks to the economy in a piece this week in the New York Times.

No one really likes to talk about it, but it’s a big problem that isn’t going away.  Can we really count on a future Congress to deal with this problem in an appropriate manner?  Not likely if you go by how past Congresses dodged the growing Medicare and healthcare problems to the point where the current Congress has to deal with the problem during the worst financial crisis since the Great Depression.

That being said no one really knows when or how much of the money the government lent out to financial institutions it will get back.  Some people are saying taxpayers will be on the hook for most of it, while others are saying the government may actually turn a profit by selling it’s equity stakes when markets recover.

It’s not a problem as long as there is enough demand for U.S. treasuries but once it passes that tipping point all bets are off.  This country hasn’t really had an inflation problem since the recession of the 1980’s but the one that’s coming could make that one look like a distant dream.

Now the Fed could fight it by raising interest rates but that would also send economic growth down at the same time.  Since no one knows who the next Chairman of the Federal Reserve will be next year, we don’t know if a future Fed will place a premium on fighting inflation or maximizing employment.

There are too many variables to the problem to accurately determine how this will all play out but it is a cause for concern.

Although, China announced that it wouldn’t be making any changes at this time to it’s foreign exchange policy at this time, more and more countries are questioning the role of the U.S. Dollar as a global currency reserve.  China’s influence can’t be overstated, since they are the largest holder of U.S. Treasury Securities and hold over $2 trillion in currency reserves.

While they freely admit that the Dollar currently dominates global trade, there is also no question they and other countries would like to seek an alternative if possible.  We’ve also seen many petroleum producing countries, whose output is pegged to the dollar, also raise questions on having so much of their economic livelihood tied to the our currency.

With it’s fast growing economy, many expect China to become a global powerhouse in a few years and they will most likely remain the central figure on any attempts to change the status quo.  Unfortunately any attempts they make to change the Dollar’s role may not be for purely economic reasons.

China’s substantial Dollar and Treasury holdings gives it added political power when dealing with Washington and everyone knows this.  Unfortunately, there is not much the U.S. can do in the short term to undo decades of trade imbalances and deficit spending.

While we can expect further rumbling from different circles in the near future, the current fragility of the global financial system will probably make any changes in the short term unlikely.  However once the global economy does recover, we can probably expect some countries to move quickly in order to prevent future disruption to the U.S. economy to have such a far reaching effect on the rest of the world.