The Federal Open Market Committee (FOMC) of the US central bank, The Federal Reserve Board early today (August 22, Hong Kong time) cut the federal funds rate, the basis for short-term lending rates throughout the American economy, to 3.5 per cent. Our Chief Economist reports on the local impact.

It will be up to local Hong Kong banks to decide today, or in the next few days, as to whether they follow the decision by the US Federal Reserve to lower its benchmark federal funds rate by 0.25 per cent overnight.

The US cut was the seventh since the beginning of the year and brings the rate to its lowest level since spring 1994. The Hong Kong banking sector has followed all previous US rate cuts this year.

Local banks now have the freedom to set their own deposit and lending rates following the introduction of the final phase of the interest rate deregulation process in early July. Rates were previously set collectively for the banks by the Hong Kong Association of Banks.

However, it seems likely that most local banks will follow the US decision, especially the bigger banks. Overnight deposit rates are currently between 1.75 per cent and two per cent, depending on the bank, and the best lending rate is 6.75 per cent.

A further rate cut is generally positive for the local economy, which is slowing, but earlier rate cuts have so far had little, if any impact, due to the lack of confidence in immediate economic prospects, both locally and globally.

Local financial market reaction is likely to be muted, however, with the US equity and money markets not reacting at all positively to the 0.25 per cent cut. They seemed to be more worried about continuing weakness in the economy and profits, rather than the potentially positive impact of another rate cut.

The Dow Jones share market index fell on the news of 0.25 per cent cut and the US dollar immediately weakened against major currencies like the Yen and the Euro.

Before the US Federal Reserve made its latest decision it was generally agreed that it would cut rates again, the question was whether the cut would be 0.25 per cent or 0.5 per cent.

In opting for a 0.25 per cent cut, the central bank erred on the side of caution, despite the apparent weak state of large parts of the US economy.

However, the Fed was probably influenced by the fact that it has eased considerably already - three per cent since the beginning of the year - and that there is uncertainty about how quickly interest rate cuts can kick in to boost the economy.

Such an easing can have a rapid impact once it does start to work, but there is always something of a lag between the rate cut and the economic impact. Cuts in short term interest rates can take six to nine months to have their full impact on the economy.

The Fed probably also had the recent weakness of the US dollar as a concern. Although many have called for a weaker US dollar, the Fed would not want to precipitate a too rapid decline by cutting rates too substantially and frightening the markets.

A weaker dollar could cause a lagged rise in inflation through higher import prices, but with global demand weak, so too are prices of many globally traded commodities. This means there is little pricing power in the hands of the sellers and price falls could therefore offset the exchange rate effect.

The US central bank also reduced the official discount rate charged on direct Fed loans to commercial banks by a quarter point to three per cent.

Since the beginning of the year, the Fed has undertaken one of its most aggressive monetary easing campaigns in recent history in a bid to overcome slowing economic growth in the US and weak business investment. It has also indicated it could cut rates further if it is warranted by economic trends.

But the central bank has clearly become more cautious in its cuts. The first five this year were 0.5 per cent each, the last two, including the overnight cut, have been 0.25 per cent.

In its own brief commentary on US economic conditions, the Fed said US consumers were continuing to do their bit to boost the economy, but that general business conditions are weak.

"Household demand has been sustained, but business profits and capital spending continue to weaken and growth abroad is slowing, weighing on the U.S. economy," the Fed said.

"The associated easing of pressures on labour and product markets is expected to keep inflation contained."

It added that although long-term prospects for productivity growth and the economy remain favourable, "the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future".

It said it took this view against the background of its long-run goals of price stability and sustainable economic growth and trends evident in the economic information currently available.