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Fed needs to act quickly to avoid recession, says Global Strategy

The longer the Federal Reserve waits to act decisively on interest rate levels, the greater the risk that the economy will enter a policy-induced recession, warns Global Strategy.

Chief global strategist Komal S. Sri-Kumar says the Fed must not use moral hazard as the excuse to maintain the current interest rate.

He says: “In finance, ‘moral hazard’ refers to the incentive for banks to make risky loans, or for individuals or institutions to make reckless investments. The returns could be attractive on the upside, but the entities would not have to bear the full cost if things turn sour, creating the hazard. Former Fed Chairman Alan Greenspan is supposed to have contributed to such situations in 1987, 1995, 1998 and 2001 when monetary policy was eased in response to crises.”

Sri-Kumar says today, the concept of a moral hazard is regularly used by analysts to support their position that the Bernanke Fed should not lower interest rates despite the ongoing crisis.

He disagrees with the argument that a cut in the Federal funds rate would ease the plight of investors, hedge funds and buyout firms which had bet the wrong way, therefore encouraging such investment patterns to recur in the future.

Sri-Kumar says: “We find the argument to be specious. We doubt that a reduction in the Federal funds rate today would result in a surge of imprudent investments and loans.”

He says the longer the Fed waits, the more substantial will have to be the reduction in the Federal Funds rate necessary to avoid a recession or to restore a semblance of financial stability.

Sri-Kumar says: “We estimate that if the Fed were to act today, a 50 basis point move may be needed, rising to 75 basis points if the Fed waits another week or ten days, and requiring a full percentage point if authorities do not act before the next scheduled meeting of the Federal Open Markets Committee on September 18.

“Where would all this leave the Fed? The organisation that started out to differentiate itself from Mr. Greenspan’s team, was determined to avoid the Greenspan Put, and wished to stay focused on the economic fundamentals, may end up whipsawed by market fluctuations. The Fed may end up creating a new Bernanke Put, and struggling to avoid the onset of a recession.”

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