The Federal Reserve (FED) lowered its Fed Funds Rate by 25 bps to 1.75%–2.0%, the second such cut since the start of the year. The labor market is strong and economic activity is rising at a gradual rate even as global headwinds continue to cloud the outlook for monetary policy. The slowdown in global growth, rising geopolitical tensions, Brexit and trade tensions between the two biggest economies are causing business investment to wane with muted inflationary pressures. This has caused the FED and other Central Banks to turn accommodative.
The decision was as expected, with minor downward revisions to the growth and interest rate outlook, suggesting a less supportive macroeconomic picture. Global trade uncertainty has caused business investment to fall significantly, limiting the inflationary effect of monetary policy on supply-side pressures. While the FED’s policy is broadly appropriate, it remains unclear that lower interest rates will stimulate business investment amidst the sea-saw in the U.S. — China trade relations persist. This raises two broad questions.
1). Should the fed lower rates?
The decision to lower interest rates is justified by the Taylor rule, and it is safe to say that the FED’s easing bias is not completely unjustified despite continued strength in the labor market and the U.S. economy growing close to target. Even as investors might be averse to riskier assets and investments in the current climate, favorable financial conditions suggest monetary accommodation in the coming years, and this could prove powerful enough to sustain the recovery and ensure inflation converges towards its mandated 2.0% target. Furthermore, the U.S. economy is primarily driven by demand, with households’ constituting 70% of the U.S economy, it should, therefore, come as no surprise that the Fed lowered interest rates to ensure households pick up the slack from falling business investment. Interest rates will operate much more effectively via the balance sheet channel as household’s interest rate burdens will likely respond favorably to lower interest rates.
Admittedly, this is also contingent on the pass-through from policy rates to mortgage rates as well as deleveraging from households. The wealth effect — higher net worth as a result of higher asset prices such as house prices — should encourage spending on white goods such as washing machines as well as vehicles. Meanwhile, business investment is still reeling from the tit-for-tariffs and is unlikely to change in the absence of stimulus and a more accommodative framework from the Fed is unlikely to improve the outlook for consumers. The rationale for a Fed rate cut is therefore justified, as external and global factors appear increasingly relevant for the conduct of monetary policy and appear to be significant headwinds for the U.S. economy.
2) Should it focus on financial stability as the U.S. is the middle phase of a maturing cycle?
The Fed’s policy is broadly appropriate to support the expansion, but lower policy rates could increase financial stability risks. The inevitable impact of the lower policy rate is highly leveraged corporate or household sector. This trend might be true for the financial sector; as favorable financial conditions encourage risk-taking, but a different trend emerges for households (see chart). As illustrated above, the household’s debt as a percentage of GDP has been falling. This might simply reflect higher asset prices i.e housing in the case of households or a faster pace of deleveraging against a favorable economic backdrop. This explains why the balance sheet effect of a more accommodative stance might insulate household demand, somewhat, even as consumer confidence will undoubtedly reflect global trade uncertainty later in the year. This is especially true if recently increased tariffs on China go into effect by year-end.
Household debt has been falling steadily since 2010, reflecting a strong labor market, rising incomes, and a favorable economic backdrop. Meanwhile, non-financial debt to GDP ratio has risen steadily, falling only from August 2016. It can be argued that households — depending on how well capitalized they are as well asset structures might be better prepared to a downturn. This is especially true as the FED will lower policy rates in the event of a downturn, protecting incomes by lowering the debt burden. This is, however, contingent on the portion of incomes allocated to interest expense.
Households debt is falling, a boon for FED policy
The outlook is less certain for highly leveraged sectors and businesses, who might amplify the effect of the downturn by increasing the adverse transmission to the real economy. The Fed should instead focus on ensuring its stress test is more rigorous in measuring bank resilience under the most extreme scenarios for growth and inflation. The decision to ease trading restrictions under the Dodd-Frank act will most certainly increase financial stability risk and the FED will be constrained in limiting the fallout under these circumstances. It has already tweaked its policy to reduce funding pressures in money markets to support private sector tax obligation. The temporary measures are designed to relieve funding pressures to enable fed funds rate to move back to the target range. To that effect technical adjustments were made to interest rates paid on excess reserves; the 20bps cut ensured interest rates moved back towards the middle rate of the fed funds range. Meanwhile, the rate on overnight repurchase was also tweaked reflecting an inability for businesses to meet their debt obligations as concerns tax payments.
This could be exacerbated in a downturn, lessening the transmission from such institutions to the real economy. The FED could simply make policy more accommodative and improve the impact of lower or possibly negative rates on the real economy.
The Dollar might react little to interest rate cuts
The Fed’s decision to lower interest rates might do little to reduce the dollar premium, which accrued since U.S. trade policy became more uncertain. The Trump administration decision to engage in a trade and technology war with China cause the dollar to appreciate as the Chinese economy is more exposed to higher tariffs over the near term. Meanwhile, the U.S has some of the highest interest rates for advanced economies and although the impact of the pro-cyclical stimulus appears to be wearing off, it nonetheless continues to grow at, if not marginally above its long-term potential. The appreciation in the currency was compounded by a slowdown in global growth, which caused a bond and dollar bias. As such, a natural, yet higher, premium has accrued to the dollar, reducing the competitiveness of its exports also reeling from reduced Chinese demand.
U.S. President is talking up the value of the dollar by engaging in trade wars!
Trump’s rant on dollar strength is completely unjustified as he created the ideal scenario for the dollar to appreciate. Meanwhile, the interest rate differential between the United States and other economies underpin the currencies strength, at the detriment of exports. This negates any positive effects on the U.S trade war with allies and China as American exports become more expensive. Meanwhile, the United States twin deficits suggests the dollar is overvalued, but its safe-haven properties might be tested during the next downturn. The Treasury will either have to issue ultra-long bonds to reduce the propensity of a view change on the dollar’s dominance in global trade.
Central Banks are justifiably pre-emptive, but fiscal policy must be used effectively
The Fed’s mandate is unchanged but incoming information will be dictated by U.S. trade policy, the timing, and nature of the United Kingdom from the European Union and the extent of the slowdown in global growth. Global Central Banks are pre-empting adverse economic implications of geopolitical, political and trade uncertainty by cutting interest rates and lessening the fallout from headwinds. Attempting to sustain the expansion and stave off a supply-side induced downturn, they might inadvertently reduce their ability to respond to the next downturn. Fiscal policy must not only be employed under these circumstances, but it must also be targeted and effectively timed to align an economic and climate transition.
In the absence of active labor market policies and unemployment insurance to boost productivity and the potential growth rate, current inflation targets will become even more obsolete. Any attempts to achieve current mandates under such a context would prove futile. The Fed’s policy is appropriate, but monetary policy must now balance incoming risk against their ability to respond to a crisis. An easing bias might seem appropriate at first, but its effectiveness should nonetheless be overemphasized. This will inadvertently reduce the Fed’s ability to stimulate the economy is more relevant for the future effectiveness of the monetary policy.