Why the Federal Reserve Just Lowered Interest Rates?

Macro · Aug 1, 2019

On Wednesday, July 31, 2019, the Federal Reserve lowered interest rates by 25 basic points to a range from 2.00% to 2.25%.

It was the first interest rate cut since 2008.

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Why did this happen and what are the possible consequences of such a change?

Why Change Interest Rates?

Generally speaking, the Fed’s mission is to keep the US economy and the US dollar stable and the main tool that they have in their arsenal is their ability to change the interest rates. When the Fed raises the interest rates, the cost of money increases (it becomes more expensive to borrow) and it might help to slow down an overheated economy.

When the Fed cuts the interest rates (as has happened recently), the cost of money decreases so it can stimulate economic activity.

GDP Growth and Inflation

The US GDP growth has been positive and stable since 2010 and the annual GDP growth rates were within the 1.5 - 2.9% corridor. The inflation have been ranging from 0.7% to 3% since 2010. There is a slow positive trend of decreasing inflation from 2016, but before, it was much lower.

With this recent decrease in the interest rates, the US economy will get better access to cheap money, therefore the real GDP growth is supposed to go up as well. Also, the falling inflation is concerning, because too low a number suggests that the economy is too slow, so the Fed might want to boost it.

Another thing to keep in mind is the decreasing growth rate of the American population (+0.7% in 2019), numbers go down from 1992 which increases per capita GDP, but it isn’t good for a total GDP of the country. Population will continue to grow due to immigration, but the speed has to be faster for a decent total GDP increase. If the productivity is not rising, the only way to increase the total GDP is to have more people in a country.

Unemployment Rate

The unemployment rate in the US is falling down steadily, actually, its chart looks too nice. From 2011 with 9.3% rate unemployment decreased to 3.8% in 2019, which is a stunning achievement.

However, it’s impossible for the unemployment rate to keep falling, because a small number (<5%) is already considered to be normal and natural by economists. Also, it is important to understand that many people have jobs with relatively small wages and they work part-time, so employment itself doesn’t guarantee good wealth for a country.

Trump

So why would they decrease the rate if Trump keeps saying that the economy is doing great right now?

It’s interesting that Trump attacked Fed several times before, for keeping rates too high, he wanted them to decrease it, yet according to him even with high rates, the US economy is fine. The S&P 500 at a record high level, there are more jobs, jobs, jobs and Trump’s tax reform is bringing US companies back.

Trump said that with a lower rate everything could be even better and now he has a chance to prove it.

Market Reaction

When the news came out markets reacted negatively.

The S&P 500 dropped by 1.8% and some analysts said this news can’t be seen as a positive sign right now.

Decreasing rates would be a good sign in a different case, but because the market was enjoying long and stable growth, any federal changes can be seen as a warning.

European Influence

The prime rate (this is what the interest rate called in some other countries) in Europe is very low compared to the US. Here are some European interest rates set up by central banks:

  • Czech Republic: 2%
  • Poland: 1.5%
  • Norway: 1.25%
  • Great Britain: 0.75%
  • Denmark: 0.05%
  • Sweden: -0.25%
  • Switzerland:-0.75%

In other developed parts of the world the rate is also quite low:

  • Canada: 1.75%
  • South Korea: 1.5%
  • Australia: 1%
  • Israel: 0.25%
  • Japan: -0.1%

Those rates in developing nations are high and usually, it’s not a positive sign:

  • Turkey: 19.75%
  • India: 5.75%
  • China: 4.35%
  • Brazil: 6%

Business in those countries is struggling because of the high borrowing cost.

Some European countries trying out negative rates which is also a bit concerning. This means that citizens have too many savings, but not enough profitable investment opportunities, so the government has to motivate them to invest and borrow more by offering negative rates.

Conclusion

This recent interest rate decrease in the US was both expected and somewhat justified, it’s not necessarily a bad sign overall, it’s more like a correction of the previous policy.

It’s hard to say what to expect next, probably we’ll see a further fall of the rate in the next cycle, but many market watchers are predicting a major crisis because they think that some key sectors are overrated (IT, real estate, etc.).

In the case of a crisis the Fed’s policy usually would be the same - to lower the interest rates to help the economy to recover, so those people say that right now the Federal Reserve is just preparing for a massive market fall.

Although some monetary economists not in the US often would behave in the opposite way, they would increase rates to stop the inflation which naturally occurs in such cases.

analytics   economics   the united states   finance   business   interest rates   macroeconomics   banks

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