Wednesday, September 19, 2007

Problems of Cutting US interest Rates

See also: Why Fed cut interest rates

1. Weak Dollar.

The dollar has been very weak against the Euro, Yen, and Canadian dollar for several months. Reducing interest rates will further weaken the strength of the US dollar.

As US interest rates fall, it becomes less attractive to save money in the US. Therefore, there is an outflow of hotmoney from the US to other countries. This further weakens the dollar, and increased the cost of importing raw materials

2. Inflation

Reducing interest rates may cause inflationary pressures to increase. This is because it increases consumer spending and weakens the dollar. Both of which have inflationary pressure. However, others argue that if the economy is heading towards recession, inflation is not the primary problem.

3. Rewards Bad Lending.

The argument is that in recent years credit markets have performed poorly. Basically, too many bad loans have been given out. In particular, the sub prime mortgage market has helped to give mortgages to those who couldn't really afford the mortgage. By cutting interest rates aggressively it is responding to the failures of these credit markets. If interest rates are cut, the banks and consumers may not learn their lesson. Some argue that it is better to have some short term pain so that markets learn the lesson of irresponsible lending and so the crisis is not repeated in the future.
Of course, this is a more controversial argument and you are unlikely to see it repeated by many leading US politicians.

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