Heightened uncertainty

The year 2008 started off on a bad note for the world economy, with a US recession all but certain and markets across the globe caught in the pessimism. Matters are not improved when the expected losses from the sub-prime crisis keep climbing, when potential house price dips in the US begin to get compared with the Great Depression of the 1930s. The constant uncertainty in financial markets and the resulting drying up of credit mean that Wall Street is crimping Main Street, even as the general drift of macro-economic data invokes pessimism. US policy-makers, both monetary and fiscal, have moved to ease concerns about the US economy going into a prolonged slump. So, as the 75 basis point cut in the federal funds rate takes effect, with perhaps a further 50 basis point cut expected in the near future, and the $165 billion fiscal stimulus package works its way through the system, the economy is expected by some observers to show signs of recovery in the second half of 2008. But the markets remain skittish. Last Friday, the US stock market plummeted and, as has become the norm, this week began with precipitous declines across Asia. India was no exception, suffering from the backwash of the regional nervousness.

Are marketmen right to be fearful? Several factors pose a genuine threat to the ability of the US economy to confine its recession to the first two quarters of 2008. First, there is the old worry about monetary policy pushing on a string. The responsiveness of economic activity to lower interest rates depends entirely on the ability of the financial system to find borrowers. Given the state of fragility that the system is in, as a result of widespread exposure to sub-prime mortgages, it is hardly likely to be looking aggressively for more and possibly risky borrowers. Until the full extent of exposure to sub-prime is finally revealed, lenders are going to be wary of expanding their portfolios. Second, there is the ever-present threat of inflation rates rising, even as growth slows down. Oil prices have settled around the $100 mark, despite the US outlook being what it is. For the US Federal Reserve, this poses a clear challenge when it comes to further rate cuts. Already, sources within the institution are pointing to increasing threat perceptions on the inflation front. Other central banks around the world, including the Reserve Bank of India, are also emphasising the significance of the threat in their announcements. Overall, this means that a stimulus from lower interest rates becomes less likely. Outside the US and particularly in emerging markets, the inflation spectre is heightened by the sharp increases in food prices, which, apart from constraining monetary policy actions, intensify political pressure on incumbent governments. All of this does not make for a very conducive investment climate, and investors are responding quite rationally to the heightened uncertainty.

There isn't a policy response readily available to deal with this scenario of stagflation. Policy-makers must keep their fingers crossed that the US economy will respond quickly to recent stimuli, obviating the need for further rate cuts. Dealing with unfavourable food prices will necessarily involve both multi-national cooperation and a fair amount of time. Meanwhile, financial supervision and risk management need to be toned up. Even after all this, investor confidence is an elusive and fragile thing.