Which master's voice?

The governor of the Bank of England preaches monetary morality one day, only to bend to the wind, throw principles overboard, and bail out a mortgage company two days later. The head of the US Federal Reserve Board has a history of being a purist when it comes to inflation-fighting and other macro-economic matters, but he too has bowed to pressure from the markets and (as many would see it) gone overboard in his reaction. So are monetary authorities masters of the universe, or are they captive creatures of the market? The answer to that question will be debated for some time because, suddenly, the evidence is much more mixed than before. The stock markets have responded with unabashed glee, but the question will be asked: are the authorities creating a fresh asset bubble?

In opting for a 50 basis point rate cut (rather than settling for just 25 basis points, as many had advocated and perhaps the markets had expected), the US Federal Reserve Board has made its position clear on two issues that have dominated the global macro-economic debate over the past several weeks. The first relates to the moral hazard involved in central banks bailing out vulnerable investors through an infusion of liquidity, which is what a rate cut facilitates. If investors are always assured of a liquidity safety net by the central bank, the argument goes, they are encouraged to take risks that they otherwise would not have taken. But when push has come to shove, the Fed has done what lesser central banks elsewhere have been criticised for doing, dealing with the here-and-now reality.

The defence is that if the problem is confined to a segment of the financial system, with the danger confined to a few institutions going bankrupt, restraint may well be in order (though the Bank of England seems to have failed even this test last week when it bailed out Northern Rock). But if the danger of a spill-over into the larger economy is significant, the practical response would be to use monetary levers to offset recessionary tendencies. In other words, as far as central banks are concerned, the cause of a slowdown or recession is less important than the fact that it is seen to be imminent. In such a situation, moral hazard can go take a walk.

In opting for a 50 basis point cut, therefore, is the Fed saying that things are worse than they currently appear? That must be the reading, because if one goes by publicly available information on the US economy, there are as yet no unambiguous indicators of a meltdown. News from the housing sector, on prices and the financial health of both real estate developers and financiers, is of course bad, as is the news on the job creation front, but retail sales and the stock market do not provide a particularly negative picture. Given the mixed signals, a smaller reduction may have been a more appropriate response. So the only possible conclusion is that the Fed sees a bleaker future than many others do. Ben Bernanke, the Fed chairman, may also have been influenced by the economist Martin Feldstein, who has long argued that the bursting of the US housing bubble will be bad news, and who advocated a 100 basis point cut at the recent Jackson Hole meeting of central bankers and economists.

The 50 basis point cut is certainly good news for the Asian economies, whose growth momentum would have been weakened by a US recession. If financial markets stabilise fairly soon, they would have come through the turbulence more or less unscathed, but a little more sensitive to their still significant dependence on the US with respect to both trade and capital flows; enough, perhaps, to look for more ways to benefit from the region's strong performance. As for the dollar, it has predictably got weaker and countries like India will look like safer places for international capital. Those forecasting a further strengthening of the rupee may have won a bet or two; exporters should be warned.