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Global impact of lower US interest rates
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14:55, September 25, 2007

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The US Federal Reserve announced the cut of interest rates by 0.5% on September 18th. The range of growth rate exceeded market expectations. On the same day, the New York stock market index rose sharply and led to a hike in the Asian stock market index the next day. It seems that the global financial market is strongly "policy-oriented."

A recent credit crisis is the direct reason for the Federal Reserve's lower interest rates. The Federal Reserve wants to prevent a chain reaction of the subprime crisis by injecting capital and lowering interest to increase the liquidity of financial markets. The assessment on economic growth and inflation is also one of the reasons.

From curbing inflation to "rescuing the market," the Federal Reserve has changed its monetary policy goals and reached a turning point. Whether it will succeed is still in question. In essence, the subprime crisis refers to a credit crisis caused by feverish, swelling financial markets. It usually results from a lack in security of innovative financial activities and regulatory mis-control. To rescue the market, the Federal Reserve, pays for the market's mistakes by "binding" the credit of the US central bank to a crisis in local markets. There is a controversial "moral hazard" here. On the one hand, it might be able to reconcile the crisis, just as Greenspan did with the long-term capital management company bankruptcy crisis, by cutting rates in 1998. On the other hand, however; this approach is obviously a temporary solution; is likely to encourage an irresponsible market mentality; and will expand the scale of potential crisis. Due to the high degree of financial globalization, financial institutions and central banks of other countries will have to join this "show" with the Federal Reserve.

The interest rate cut will have a direct impact on China. First, China is on its way to raising the interest rate as an effort to fight inflationary pressure and excess liquidity. The Federal Reserve's interest rate cut will inevitably narrow down the room for the macro-control measures of China. Second, pressure on the appreciation of the Renminbi will be intensified. Third, the impulses of external capital inflow will be strengthened; and they might offset the anti-inflationary policy effects of the central bank. Fourth, China's huge foreign exchange reserves will show a more prominent trend of devaluation.

The Federal Reserve's action implies a "soft dollar" policy. In fact, the ratio between dollars against a basket of currencies has declined by about 25% since 2002. The recent rate decrease will make the dollar more "soft." Experts believe that a weak dollar will not reduce imports to the United States, but will only aggravate a price hike. Another possibility is that wealthy countries will invest more in stronger currencies, and get much more involved in mergers and acquisitions; thereby, changing the power structure of world currency.

In the current global context, excess liquidity is a long-standing fact. The Federal Reserve's action will even further aggravate the situation. Whether it will cause global inflation and asset price hike is an issue worth noting.

How far the Federal Reserve will go depends on its judgment of the situation and value. Either accelerating inflation or rapid depreciation of the dollar will lead to an interest rate increase. An "overly-soft" dollar will also do harm to the United States. After all, it relies on the daily influx of more than 20 billion dollars to pay for imports and foreign debt interest costs. Therefore, the United States has to keep the dollar attractive.

A monetary policy is a major tool for adjusting the "temperature" of economic development; and aims to maintain healthy economic development. Neither "overly-cold" nor "overly-hot" economic development is preferred. The government should adopt a symptomatic, timely and appropriate monetary policy. "International Financial News" recently published an article entitled "Lower US interest rate tests Chinese central bank's wisdom." This is a vivid description.

By People's Daily Online

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