Comment: US resorts to desperate measures to stimulate economy

The pace of economic decline has intensified and policymakers are rapidly running out of ammunition. With interest rates falling towards zero, there is talk of “quantitative easing”, a polite way of describing printing money. In normal times we associate this practice with countries such as Zimbabwe. But fears of slump and deflation are forcing extraordinary measures.

Rates
The US is leading the attack. The Fed’s policy rate is still 1%, but a cut to 0.5% was expected by year-end 2008, and a move to zero cannot be ruled out. Even before reaching this extreme position, the Fed acted aggressively to increase money supply.

The policy also aims to influence longer-term yields, not just overnight rates that the Fed usually controls. US Treasury bond yields fell to levels not seen for decades and Treasury bill rates were zero or negative.

Other major countries are following the US but at a slower pace. The European Central Bank has cut its policy rate to 2.50%. Though the cut was the biggest in the euro’s 10-year history, it still disappointed the markets as being inadequate in the face of mounting recession threats. Further eurozone rate cuts are expected early in 2009, at least to 2.0% and possibly to 1.5%.

The UK has intensified its policy easing; it is now the most aggressive European rate cutter, with Bank rate down to 2% in December, the lowest for 50 years. In spite of sterling’s sharp fall, and the risks it signals, the UK will probably cut rates to 1% early next year.

Borrowing
By pledging to buy up to $600bn mortgage-backed assets and offering to lend $200bn to support other loans (eg, car, credit card), the Fed has expanded hugely its balance sheet and is already engaged in quantitative easing.

Congress has also agreed bailouts to the ailing car industry. President-elect Obama’s newly appointed national economy team is set to introduce a massive fiscal package immediately after the 20 January inauguration.

Few doubt the US’s determination to avoid a slump, but the risks to US creditworthiness are real. Stimulus is the correct policy, but unless the US shows foresight and political will to change course before inflation re-emerges, the consequences could be appalling.

Chinese developments have been ominous and the leadership is very worried. As well as slashing interest rates, China has started to reverse the yuan’s appreciation. If China, with its massive trade surplus, devalues on a big scale, risks of a destructive trade war with the US would escalate.