Asia Remains The Last Man Standing

Last week, the US Fed raised its key rate by 25 basis points (bps) ? a development almost universally anticipated by the market. Earlier in the month, the Bank of England decided to hold its key rate unchanged (albeit at a much higher level than the US Fed rate), as did (more expectedly) the European Central Bank.

It is quite clear now that the recovery as it is, in the economies of the US, Eurozone and Japan, has indeed turned to be weaker than most worst-case scenarios. The enthusiasm about Japan?s smart recovery through the winter and spring of 2004 did not survive the summer. The continental economies of Europe lumber along, admittedly within the range of the modest expectations of forecasts. Part of the blame can be laid at the door of spiralling crude oil prices, but weakness in basic macro parameters is the more appropriate candidate. Fiscal stress, huge current account deficits, increasing difficulties to cope with the post-World War II social contract of welfare is exacting a heavy price. That Britain is such an obvious exception must draw attention to the long-term fragilities that weak macro parameters inevitably create.

But if this somewhat bleak picture is indeed an accurate one, why did the US Fed raise rates at all? My guess would be mostly because the historically low rate regime was simply no longer sustainable.

It used to be conventional wisdom that in the presence of large fiscal stimulus, monetary policy becomes ineffective. In the current cycle however, the low interest rate regime was presented as a facilitator for the fiscal stimulus ? $500 billion worth and (disconcertingly) the same magnitude as the current account deficit. When all of the growth is eventually accounted for, the cost-benefit of the stimulus package might make engaging reading. That apart, the US Fed in its 21 September statement said that it ?perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next quarters to be roughly equal?; a synonym for ?roughly equal? would without doubt be ?neutral?. If monetary tightening is deemed necessary with a ?neutral? outlook, the only reasonable explanation for the action has to be found in the suggestion made earlier that it was incumbent for the Fed to come out of the historical low rate regime simply in order to remain credible and be perceived to be on top of the situation. Had it not raised rates, asset markets might just have taken it to be a signal that economic conditions were weaker than suggested by the phrase ?have regained some traction? ? in both the press statement of 21 September and chairman Greenspan?s 8 September testimony to US Congress.

The minutes of the previous meeting held on 10 August ?04 that also had raised rates by 25 bps makes for interesting reading. It begins with ?economic growth softened somewhat in recent months? and continued to observe that employment growth had slowed in June and July, that weakness was seen in retail trade, information and financial services, industrial output had dipped in July, consumer spending growth was slowing, and business investment outside transportation and hi-tech sectors showed little growth. The good news was that the rate of inflation, after excluding the impact of petroleum prices, had reversed direction, moderating in May and June ? something that was also to hold in July and August. In spite of this, the decision was to raise rates and do once again in the next meeting. This is not about cooling an over-heating economy, but all about sustaining the credibility of the system.

All of this leaves the Asian region (including Australia and New Zealand) as the major focus of economic growth. In the world?s perspective this focus is mostly equated with China; some of the rapid growth in Australia, as well as that in Southeast Asia and other parts of East Asia, are being driven by China?s economic expansion. The next few years provides India with the opportunity to make an indelible impress and establish that it is indeed possible to accelerate growth to well over 7% in an open society.

The author is economic advisor to ICRA