Forecasts for US Interest Rates

In recent weeks, US interest rates have been cut to 3%. The Fed are still forecasting economic growth for the year of 1.5%. However, there actions suggest they are concerned about the prospects of a recession, if they did not act decisively The cut in interest rates by over 1%, in a short space of time, is a bold move, which is aiming to avoid a recession and prevent a crisis in the US housing market.

However, the cuts may have left less room for future interest rate cuts. Despite a slowdown in growth, inflationary pressure do still remain. These are mainly cost push factors, such as rising oil and energy prices. The US is also suffering from rising prices of wheat and ethanol. The Fed may feel it is better to allow an increase in cost push inflation than risk a slowdown in growth. However, there is a danger that if cost push inflation increases it may change people's inflation expectations and could lead to wage inflation and increase future inflationary expectations. Therefore, the Fed will need to balance interest rate cuts against the ever present danger of inflation.

Monetary and Fiscal Policy.

An important criteria for interest rates, is what is happening elsewhere in the economy. If the government push through a large sized expansionary fiscal boost of tax cuts, then the need for interest rate cuts may be lessened. This is because the boost in consumer spending may be sufficient to avoid a downturn in the economy. Another advantage of using fiscal policy rather than interest rate cuts, is that it supports the dollar. Interest rate cuts, make dollar holdings less attractive. Therefore, when the Fed cut interest rates, they further weaken the dollar. Although, they have not been really concerned about the declining dollar; in the back of their minds they will want to avoid a complete collapse in the dollar. This is an incentive to avoid cutting interest rates more than necessary.

How Serious is the Housing Crisis?

A good question to ask is how serious is the housing crisis? If US house prices fall or even if the rate of decline increases then the economy will be pulled closer to recession. This could create need for further interest rate cuts. There is some evidence to suggest that house prices in the US, may still have further to fall. Many on balloon mortgages are soon coming to the end of the special low introductory rates. When this period ends, their interest rates will rise causing the possibility of more mortgage defaults. If this occurs the housing market problems will continue into 2009 and potentially beyond.

Liquidity Trap

The other issue the Fed may be aware of is will future interest rate cuts actually stimulate spending. The liquidity trap refers to the situation where lower interest rates don't actually stimulate demand.

See also: Predictions for US dollar