The Federal Reserve is caught between a rock and a hard place.
The current circumstances in the global economy are difficult because of the ongoing trade war between the US and China. The highly-publicised tariff increases and slow progress in negotiations have not been helpful to business confidence.
The US economy is still in growth territory but at around two percent it can be described as steady rather than robust. The longer it takes for the world’s largest economies to reach a deal, the more collateral damage is done to the global and regional economic systems.
The interest rate markets have entered a bizarre new set of circumstances.
With negative or low interest rates in most of the world’s developed economies, the credit bubble is billowing into the future. If it bursts when interest rates go up again, repayments will be more difficult and defaults more likely.
It could also burst if the world’s economy weakens any further and businesses go bust.
This is the Federal Reserve’s ‘rock’.
The Hard Place
Inflation is the hard place.
Price growth for October was 1.6 percent and has consistently missed the Federal Reserve’s target this year. This means that there’s not as much support for the prices of goods and services as the central bank would like.
Weaker price growth brings an element of instability into the economy.
Fed rate cut
The Fed has cut interest rates three times so far this year, obviously concerned over the growing signs of slipping investor confidence. The hard fact is that the manufacturing sector is in decline because exports to China are shrinking rapidly – along with the revenues they generate.
When companies have more difficulty earning revenue and profits, their tax payments also decline and then the state could run into cash flow problems, leading to more difficulty repaying sovereign debt.
What happens when the Federal Reserve cuts rates?
Banks peg their interest rate policies to a nationally-recognised benchmark set by the Federal Reserve. The central bank uses its key overnight deposit rate to guide retail and institutional bank interest rate policies. Most commonly, lending rates to consumers and businesses fall along with the Fed rate cut, making it easier to borrow.
Theoretically this stimulates the economy because investors and consumers have easier access to capital they can use to create jobs and grow their companies.
But it can be a double-edged sword if the economy starts floating on too much debt. The risks to the economy can be increased if debtors default on their loans, damaging the banking sector.
Rate cut impact on currency
The USD can lose value in the wake of an interest rate cut because investors perceive that USD-denominated Treasury bonds might not make as high a return as they expected.
A sell-off might push down the USD’s value but at the same time, it could help lower the price of exports from the US.
Going into 2020, the Federal Reserve’s interest rate policy depends heavily on developments between the US and China. If trading relations improve between the two countries, the Fed might start thinking about pausing interest rate cuts and keep them unchanged for a period until the economy and inflation start growing more strongly. Investors should pay close attention to the FOMC monthly statement and focus on US-China trade talks for signals about the Fed’s rate policy in 2020.