• 
• 

Published on September 21, 2007

It remains to be seen whether the aggressive US benchmark interest rate cut of 50 basis points to 4.75 per cent will work magic. The US Federal Reserve sprang a big surprise with this sharp cut on September 18 in order to calm sentiments in the financial markets and to restore the US economy. The impact from the sub-prime mortgage crisis and a possible economic slump featured prominently in the Fed's decision. Inflation, which previously emerged as a policy concern, was played down this time in favour of a need to prop up the financial systems.

The immediate market reactions included weakening of the US exchange rates against the world's major currencies and fluctuation in oil prices causing a new high at US$82.51 per barrel before a retreat on profit-taking. But oil prices are likely to hover at a high plateau for the foreseeable future.

The two-year Treasury yield fell sharply, the Fed funds futures contracts pushed higher, and equities rallied.

The Fed's statement said: "Today's [Sept 18] action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets ..."

The inclusion in the statement of "some inflation risks remain, and it will continue to monitor inflation developments carefully" might be to mitigate the risks of overreaction in financial markets, and to signal that the 50-point move could be an exception rather than the norm. But the Fed remains cautious as the effects of the ongoing correction in housing, the fickle state of financial markets and the downside risks to the broader economy are still evolving.

So how will the rate cut affect Thailand?

The Finance Ministry, the Bank of Thailand and the export sector have for now adopted a wait-and-see attitude. Their initial reaction is that the Fed's move will lift the US economy and this would in turn benefit Thailand's exports.

The Stock Exchange of Thailand, along with other stock markets, reacted positively with a sharp jump in equity prices. Both the Finance Ministry and the Bank of Thailand played down fears that the weakening dollar would contribute to the strengthening of the baht.

However, Chalongphob Sussangkarn, the finance minister, believes an expected economic recovery in the US as the result of the Fed's hard-nose policy would actually lead to depreciation of the baht against the dollar.

The BoT said the US rate cut did not necessarily mean the central bank would follow suit, as the country's monetary policy would be decided primarily on domestic economic conditions.

The BoT will be faced with a dilemma, when the time comes, whether to maintain the policy rate of 3.25 per cent. Will it cut the rate by another 25 basis points, as expected earlier by the financial markets, to both stimulate the economy and keep the baht weak at a time when inflation remains subdued? Or will it decide to maintain the same rate, as the Thai economy is likely to recover next year after the formation of a new government, which is expected to precede massive investment into the economy.

The central bank's main priority is to make sure that the setting of the interest rate continues to be a reliable tool to curb inflation. Further lowering of interest rates at a time when oil prices stay high could deprive the BoT of the ability to keep the core inflation rate within the 0-3.5 per cent range.

This is not to mention the fact that high oil prices will contribute, in no small way, to the rise of inflation.

By the second quarter of 2008, Thailand's recovery might be in full stride. Then there might be a risk that manufacturers will pass on the pressure of price rises to consumers and businesses. The central bank would then be hard pressed to reverse its monetary policy by raising the rate in a new round of interest rate hikes.

In the meantime the central bank is closely watching the impact of the US sub-prime loan crisis to see how it will affect capital movements into and out of Thailand and the region. It is no easy task to manage Thailand's macro-economy during this time of global financial turmoil.