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The coming US Federal Reserve rate cut. UK and Europe will follow despite rising inflation.

Posted by Adrian on December 6, 2007

It is widely anticipated that the Federal Reserve will cut interest rates (now at 4.50%) by half of a percent or 50 basis points after their meeting on December 11th, it would be also expected that the discount fund rate (now at 5.00%) will also decrease by 50 basis points. This anticipated rate cut has somewhat spurred the erratic Dow Jones to rally at the mere thought of a Fed cut.

Is aggressive rate cutting going to do anything to reinvigorate the US economy? Probably not, in fact most likely not. Can it help the US economy from sliding into a severe recession? No.

The problem is the contraction in the banking sector, banks have all reevaluated their balance sheets as borrowing capital has become scarce, due to the credit crisis which has enveloped the financial world. The credit crisis that most people should be aware of now, stemmed from the US sub prime mortgage market collapse. So all the banks and lenders will be tightening their requirements to lend capital to consumers and other banks. It should also be noted that cutting rates is on the speculation that the poor consumer will reemerge with more debt, hence borrowing more funds to purchase more assets (which are falling in value anyway i.e houses). But as I just mentioned, the banks will be in a position of frugality with their lending practices and less like they were in the midst of the housing/worldwide economic boom (giving out credit). In fact fees and general costs will be past down to the consumer, this is happening all around the world. Retail banks independent of their reserve banks, are increasing fees, tightening credit lines and limiting their general exposure to ‘risk’. Again it seems like all aspects of the financial markets these days are become more disproportional, while reserve banks cut rates, retails banks will increase rates, or limit their exposure to uncertain risk markets. So any continued economic expansion on the reliance of credit is over.

But the real danger in a worldwide rate cutting policy, if to avoid a worldwide recession, is inflation. You don’t have to be an economist to see the price of living has increased at a rapid pace. This can be seen with food, fuel and service utilities. With food shortages occurring in Europe and the southern hemisphere, the costs of wheat, milk have increased dramatically. From Reuters: World face food shortages, price rises.

“The world eats more than it produces currently, and over the last five or six years that is reflected in the decline in stocks and storage levels. That cannot go on, and exhaustion of stocks will be reached soon,” he told a conference in Beijing.

Countries such as Mexico have already experienced food riots over soaring prices, von Braun added in a report released at the same meeting, held by the Consultative Group on International Agricultural Research.

“The days of falling food prices may be over,” said von Braun, lead author of the “World Food Situation” report.”

Europe is now showing it’s vulnerability to any credit crunch crisis, more particular at this point is the UK. With a good chance the Bank of England will cut rates after the 6th December 2007; the European Central Bank may do the same, or hold rates. Whatever the case the greater European Union will occur higher inflation, from FT.com Pressure intensify on Bank to cut rates:

“It faces a current problem in balancing the risks of slowing activity with those of rising inflationary pressures.

The British Retail Consortium on Wednesday said higher food prices had fuelled the highest rate of shop price inflation so far this year.”

Cutting rates is a pointless and dangerous exercise for the reserve banks of the world to consider at this point in time, falling currencies and rising costs namely food and fuel leaves no room open for expanding exports markets to thrive in (a theory of an appropriate rate cut). What should be taken into account is the depreciation of currencies and higher costs for general living expenses, not to mention the huge accumulated debt from individuals. The ever growing threat of de-pegging USD from countries that have oil ‘power’, whether countries like Iran and Venezuela have the balls to completely de-peg their currencies from the dollar and swap to a volatile Euro remains to be seen. But a massive reserve sell off of the USD from China and Japan is a very real possibility.

And if the UK does cut their rates and Europe may follow, amidst of higher inflation, then there will be no ‘quality’ currency left in the world.

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