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Friday, 20 April, 2001, 17:39 GMT 18:39 UK
Can interest rate cuts revive the US economy?
by Peter Jay, the Economics Editor of the BBC

Dramatic interest rate action by the US Federal Reserve this week has focused attention on the weapon in question. Will the reduction in US interest rates to 4.5% be enough to revive the flagging US economy?

And should the European Central Bank take similar action to avoid the slowdown reaching Europe?

The aim of the central bank intervention is to steer the economy between the twin perils of inflation and deflation, where prices do not rise too much while the economy grows steadily at its full capacity.

The problem is that price rises - or falls - usually lag behind any economic expansion by around 18 months, making it difficult for policy-makers to judge the right moment to intervene.

Too little, too late?

Some argue that the Fed's aggressive intervention now is indeed too late - and it should have acted last summer when the first tentative signs of a slowdown began to appear.

In the past, policymakers have relied more on fiscal policy - raising or cutting taxes -and direct controls on lending or the money supply, rather than interest rate cuts.

Beyond that, in early post-war economic history countries attempted to use incomes policy (direct control of pay and/or prices) and other forms of economic planning (for example regional policies) to achieve their economic objectives of growth and price stability.

Interest rate tool

The central role today of interest rates reflects a number of factors.

  • The perceived failure of fiscal policies like tax cuts (though that was at a time when fiscal policy had a different goal of high employment);
  • The failure of incomes policies to deliver price stability during economic booms;
  • The alleged impracticality in modern financial centres of direct control of the money supply;
  • The ease in which interest rates can be changed, compared to the difficulty of getting legislative approval for tax cuts;
  • The revealed power of even small interest rate changes to move large quantities of money - as one celebrated English economist once remarked, "a change in the Bank rate can attract money from the other side of the moon" .

Uncertain result

Since the impact of an interest rate change takes several quarters to have any effect, economic managers have to try to forecast the future accurately in order to decide what action is needed.

This is where the greatest scope for error enters, though it is arguable that if the forecasting model can be fully specified, then the interest rate action could and should follow automatically without any need for the cost and prestige of a finance ministry or a central bank.

In practice such an arrangement would not today be credible; and democracy likes to hold some person - not a computer - responsible, especially if things go wrong.

Nonetheless in many countries short-term economic management has been depoliticised and handed over to an independent central bank.

In general inflation has been lower in the past decade than at any time since the 1950s.

But, as the rapid slowdown in the US economy shows, the business cycle still seems to be an unavoidable feature of economic behaviour.

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