In August and September stock markets bottomed out after a brutal sell-off caused by the subprime crisis. In the following two months, markets rallied after the Fed cut the federal funds rate by 75 basis points to 4.5 per cent.
Investors initially cheered these steps driving US exchanges to new highs in October. At that time, people hoped stability would return to the subprime market. However, it now looks like this medicine provided the stock markets with just a short-term fix.
Instead of curing the deep wound, it has become worse. During the last couple of weeks, stock markets have tumbled again severely. The problems at the credit markets have persisted and have not yet been solved.
As bad as the Depression
This is despite a group of major American banks, including Citigroup and Merrill Lynch, trying to calm the markets down by stating that the worst is over. However, recently, Wells Fargo, one of the biggest mortgage companies in the US, stated that the current credit crisis is the worst since the Great Depression.
Due to the lower interest rate in the US, the dollar weakened even further, touching all-time lows against major currencies like the euro and the Japanese yen. A weaker dollar also drove oil prices and gold prices to all-time highs: gold hit $840 and West Texas Intermediate oil went through the roof and touched almost $100.
So the negative effect of the Fed's actions led to inflated gold and oil prices. The next question we could ask ourselves is: what about inflation? Amazingly, inflation in the US stayed low. However, Ben S. Bernanke, the Fed's Chairman, said during a congressional testimony on November 8 that, 'high commodity prices and a weaker dollar may stoke inflation for a time, even as economic growth is likely to slow this quarter.'
This statement is a cause for concern because higher inflation and lower economic growth are not a good combination.
Fed gives Europe problems
Jean-Claude Trichet, the President of the European Central Bank (ECB), has received, indirectly, a big problem from the Fed. Not only has he been confronted with higher than desired inflation but also the strong euro could affect the European economy negatively. He even used the word 'brutal' to describe the strong (euro/dollar) currency move.
The ECB is keeping an eye on inflation rates rising above the ceiling of 2 per cent as the interest rate in the euro zone may then need to be increased. If the ECB does increase the interest rate from the current level of 4 per cent, not only could the economic growth in the European region be hurt but the greenback could weaken further against the euro.
In conclusion, the subprime crisis is still very much alive, the dollar is still weak and inflationary pressure exists. This leaves us with a big question or two. How deep is the current subprime crisis and how many hidden negative surprises are still out there? Also, to what extent will the world economy be affected? Remember that commodity prices are highly influenced by the state of the economy.