TO CUT or not to cut US interest rates: debate continues to rage across markets. It is the single most important question in the economic world. And it will have dominated discussion at the annual get-together of world central bankers this weekend at Jackson Hole, Wyoming.
Until Friday, the mood on Wall Street was about as upbeat as sulphurous mist over an ominously bubbling volcano. But spirits were visibly lifted by a further hint from Ben Bernanke, chairman of the Federal Reserve, that the central bank will "act as
needed" to keep the credit crisis that has unhinged Wall Street from hurting the US economy.
While not a nailed-down pledge from Jackson Hole, and one ambiguous as to timing, it was taken by the market as a 'bias to cut'. Also helping sentiment were proposals announced by President George Bush to help tackle and contain America's spreading sub-prime loan default crisis.
But does the package mean that the US Fed no longer has to cut interest rates on September 18 as loudly demanded in the markets?
And what does it mean for the UK? The Bank's Monetary Policy Committee meets this week to decide whether to raise interest rates from 5.75% to 6% - a rise that seemed a certainty earlier this summer. But the liquidity crisis and market turbulence of recent weeks has thrown this apparent foregone conclusion back into the melting pot.
Given the huge uncertainty in markets as to how this crisis will play out, MPC members have good reason to be more than usually cautious. Eurozone demand is likely to undershoot expectations during the current half-year, to the likely detriment of UK exports. In addition, there is clear evidence that the housing market is off the boil. According to the Land Registry, prices barely rose in England and Wales between June and July, and annual growth slowed from 9.2% to 8.8%. Even the Nationwide's index for August showed annual growth slowing to 9.6% from 9.9%. Some areas are now reporting falling house prices.
There is another intriguing quirk to the interest rate debate here. The sterling one-month interbank deposit rate has risen by 57 basis points since the last MPC meeting, and is consistent with a Bank rate of 6.25%. Even the one-week rate, which usually shadows the Bank rate closely, is now 35 basis points above the official rate.
As Stephen Lewis of Insinger de Beaufort points out, since market rates determine the cost of credit to borrowers, there has effectively been a substantial tightening in monetary conditions over the past month. If the MPC believed the widening in market spreads over the Bank rate would be long-lasting, it might well feel that a cut in the Bank rate, aimed at bringing market rates back down to the levels intended, would be the appropriate action to take.
That looks unlikely. But another factor staying the MPC's hand in raising rates is the latest inflation figure. This showed a further sharp drop in inflation to 1.9% - below the official target rate. This should bolster the MPC's confidence that inflation expectations will remain well contained. So a no-change decision looks the likely outcome this week.
In the US the decision is less clear-cut than it might look. Last weekend a cut in the 5.25% Federal Funds Rate looked virtually assured, but an increasingly ethical tone has crept into the argument. A cut has been likened to the world's biggest central bank promoting a market in lemons.
In today's conditions, if buyers cannot tell the difference between 'good' financial products and the lemons - those infected by poor-quality paper such as sub-prime mortgage debt or a proxy of it - then cutting interest rates does nothing to get rid of the problem lemons. In fact, it prolongs their life. A rate cut would bail out investors who had taken excessive and imprudent risks. It might feed the fruits of growth, but also water the lemons. Better, then, to do the ethical thing and let those banks and investment houses that have traded in sub-prime or toxic paper bite the bullet.
But others say it's not the job of the Fed to strike moral poses. The job in hand is to prevent the turbulence in financial markets from triggering an economy-wide recession, and to use all the tools at its disposal to prevent unnecessary damage. As Bernanke has pointed out, the "downside risks to growth have increased appreciably". And what is morally superior about the Fed standing by and watching the economy slide into recession?
The macro-economic case for a rate cut to prevent a sharp slowdown is growing in strength. Figures in the past week showed house prices in America falling by 3.2% in the second quarter compared with the previous period in 2006, the sharpest fall since the US National Home Price Index began in 1987.
Figures out last Thursday also showed that the number of Americans filing claims for unemployment benefits rose for a fifth consecutive week, increasing by 9,000 to 334,000 in the week to August 17, the highest level since April. Some of those gains probably came from rising layoffs in the mortgage industry, where many firms specialising in offering sub-prime loans have had to cut payrolls or shut down.
And taking comfort in the fractional upward revision to second-quarter GDP numbers is surely to clutch at straws. While annualised growth hit 4%, the second half of the year is set to see a marked slowdown. Moreover, consumer spending, which accounts for two-thirds of total US economic activity, slowed in the second quarter, growing at an annual rate of 1.4%, less than half the first-quarter increase.
So, clear-cut then? Not quite. The big worry is consumer confidence, and spending in American malls. Confidence indicators have been mixed. But figures on Friday showed that Americans returned to the shops in July after taking a breather in June. According to the Commerce Department, consumer spending rose by 0.4% in July, double the June increase. The spending was supported by a solid 0.5% rise in incomes.
And new orders at US factories jumped by a bigger-than-expected 3.7% in July and 2.4% without the volatile transportation component.
After all this, the measure most likely to tip the scales in favour of a rate cut is inflation, which the Fed is charged to combat. According to the latest figures from the US Commerce Department on Friday, a core inflation index rose just 0.1% in July, holding the year-on-year increase to 1.9% for the second straight month.
George Davis, chief technical strategist at RBC Capital Markets in Toronto, said: "It doesn't seem like pricing pressures are moving out of control." And that, for Bernanke, could prove the clincher.
