The signals - GDP growth, personal income, retail sales, consumer confidence, non-farm payroll, factory orders, corporate profits, etc - are uniformly negative for the past few months in United States. Nasdaq, the US tech exchange after hitting high of 5000 in March seemed poised to touch the abysmal values. What exactly are the reasons for such a sudden downward draft?

Over the last decade, the US economy has experienced a sharp acceleration in productivity growth. This prompted a surge in capital spending. Expectations of higher profits resulted in an unbelievable rally in the equity markets over the last five years. Nasdaq rallied from the start of 1995 and increased by a whooping 5.8 times till March 2000. Capital market rally resulted in the 'wealth effect', which further fueled the economy. American's saw their investments in equity markets growing dramatically in value. Creation of this wealth led to a significant increase in household spending.

Meanwhile, the wave of technological investments in the US economy has engendered a pronounced rise in the rate of high tech investments, there by stepping up the pace of capital spending and productivity growth. The surge in this productivity has enabled the US economy to grow at a much faster pace. However, Greenspan, the chairman of Federal Reserve felt that the US economy cannot grow any further at a pace of 5 or 6% without sooner or later running into problems with inflation. As a result, from June 1999, they raised the interest rates six times within the period June 1999 to May 2000 for a cumulative increase of 1.75 percentage points.

By increasing the cost of credit, the Fed hoped to curb corporate investments in new machinery and factories, and spur companies to downsize and carry out other cost-cutting measures. Despite the increase in interest rates, there were no signs of cooling of US economy. The IMF economists asserted that the Fed has not done enough to slow the rapid pace of growth of economy. It warned that a delay in raising interest rates would have serious repercussions not only for the US but also for the rest of the world.

So, on May 16, 2000 the Federal reserve raised key interest rates by half percent point - the largest increase in five years. This was a move aimed at driving unemployment and suppressing demands from workers for improved wages and benefits. This aggressive move had set into motion recessionary forces that inevitably led to a sharp downturn in the economy in the subsequent months. The fed also raised the discount rate it uses when lending to private banks to a nine-year peak of 6%. On the same date, the Fed increased its benchmark federal funds rate(the rate the banks charge each other for overnight loans) to 6.5%, the highest since the recession of 1991. 

These factors had resulted in the economy slowing down and the inflation rates were also under control. Equity markets too have been in a downturn since then. Oil prices moved up this year and touched a ten-year high. The firm oil prices have impacted the economy and energy costs of non-energy corporations have increased by about 40 per cent from the mid- 1999 levels. This has eaten into the margins of the companies. Hike in the oil prices has also worked as a tax of roughly one-percent on the consumer.

Numerous dot-com ventures have failed in the last few months and major technology companies have issued profit warnings. Risk perceptions in the equity market also have changed with increase in default rates on less than investment grade bonds and numerous debt-rating downgrades. Banking system had tightened the lending standard and terms.

The only gainer from the slowing US economy has been the Euro. The currency has moved up to touch 0.8975 due to all around dollar weakness. This could be a good opportunity for ECB to intervene to take Euro above the 0.90 level.

The Federal Reserve after confirming the fall in the growth, have just started their action. The first step was taken by reducing the interest rates by 50 basis points to 6% and followed it up by another 25 basis point cut. This move had spurted the Nasdaq by 14%(up 325 points), the biggest gain on a single day in the history of Nasdaq. Dow increased by 3%. Hongkong's Hangseng shot up by 645 points (up 4%). The Federal Reserve Chairman has also declared that it would further reduce the interest rates if felt necessary to safeguard the US economy. Thus Fed may have to resort to a few rate cuts to prevent a hard landing.