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End of cycle: why did the US Federal Reserve cut its rate

UNITED STATES, WASHINGTON (OBSERVATORY) — The US Federal Reserve has lowered the refinancing rate for the first time in 10 years. Although the mitigation was the very step that the US administration demanded, a specific decision to cut the rate by 0.25 percentage points was criticized by the American president due to lack of decisiveness.

The markets did not like the decision either: stock indices sagged strongly around the world. Izvestia explains why a key rate is needed and why the decision to cut it on July 31 can be extremely important.

What is the Fed rate for?

The main difference between the base rate of the US Federal Reserve (federal funds rate) and, say, the key rate of the Bank of Russia is that it does not regulate refinancing of the banking sector with money belonging to the regulator. It is rather an indicator of the rate at which banks themselves provide short-term (overnight – for one night) unsecured loans to each other.

This is done through the mechanism of reserves, some of which any commercial bank must keep in the Fed. For loans (both unsecured and repo) directly by the Fed’s money, there are other rates, they are also important for the market, but generally fluctuate along with the base one.

The Fed decides on the rate at meetings of the open market committee, which are held up to eight times a year. Most often, the rate remains at the same level or increases / decreases by 25 base points (a quarter of a percentage point). Nevertheless, in some cases, a bet changes in any direction by 50 or even more base points. Basically, the Fed is trying to avoid sudden rate movements without sufficient need for that.

The impact of rates on the US economy is huge. Getting free funds at a low interest rate, banks have access to huge reserves of liquidity, which increases their ability to give long-term loans to each other, to commercial enterprises and to the population. The movement of money in the economy is accelerating, and with it business activity. On the contrary, if the interest rate is high, banks also increase interest and generally give loans less actively, as a result of which the economic growth is inhibited.

However, keeping the bid too low constantly is also impossible. This leads to flooding the economy with money and accelerating inflation. In addition, due to the easy availability of credit, funds can be invested in obviously inefficient projects and form financial bubbles, for example, in the real estate market. This is exactly what happened with the US economy in the late 2000s.

As a result, the task of the Federal Reserve (as, indeed, of any central bank in the world) is to maintain a balance between supporting economic growth and stopping the inflationary threat. In a situation where there is a likelihood of an “overheating” of the economy, rates should rise, and when economic growth is sluggish or even a recession takes place, they should be kept low. The hardest part is determining the right moment for the intervention. Such a policy is called countercyclical, because by regulating the monetary sphere, the Fed softens the harshness of the phenomena of the economic cycle, which is characterized by rapid ups and downs.

The difference between the Fed and other world Central Banks is the global importance of the American economy. The USA is the main consumer of the world, the largest financial market and the issuer of the most popular reserve currency. The actions of the American Federal Reserve thereby affect the world economy to a much greater extent than any other central bank. That is why every meeting of the open market committee is closely watched by bankers, economists, and even politicians in almost all countries.

Is the current rate high?

The Fed last lowered its rate at the end of 2008, amid an acute phase of the financial crisis. However, at that moment it dropped to record low indicators – 0-0.25%. Prior to this, even a decrease to 1% was an exceptional phenomenon and took a rather short period of time in the early 2000s. The last time she stayed at zero for more than six years. Moreover, the rate cut was then accompanied by other unprecedented support measures, for example, a “quantitative easing” program, which meant buying up trillions of government bonds. All these steps were justified by the most severe recession in the American economy, which became the most serious after the Great Depression of the 1930s.

Only in 2015, the Fed again began to raise rates, but very slowly and carefully so as not to “frighten off” the still sluggish economic growth. By the second half of 2018, the rate growth stopped, despite the fact that the GDP growth rate almost completely recovered after the crisis.

At the moment, the situation in the US economy looks good enough not to lower, but raise the rate. The unemployment rate is 3.6%, one of the lowest in the last half century. Economic growth slowed down a little, but still remains at a very solid level – 2.1% in the second quarter. No Western European country can boast of such indicators, even despite the fact that rates are now significantly lower in the eurozone. Over the past few years, inflation has for the most part kept below 2%, so in this case, too, it cannot seriously affect the decisions of the Fed.

The situation in the stock market, if it causes concern, is only in terms of revaluation of assets. Stock indices last year are located near record levels, which are steadily updated. In a normal situation, this signals an overheating of the economy and the need to tighten rather than soften financial policy.

Why is Trump unhappy with the Fed?

Nevertheless, there are some reasons for concern. First, in America, business activity in industrial production has slowed down quite a lot. A year ago, the PMI index exceeded 55 points, now it is at the level of 50 points (values ​​above 50 indicate growth, below – a decrease in activity). Although industry in the United States is not in first place in its share of the economy, the recession is an important leading indicator. The service sector responds to changes in the situation with some delay.

Secondly, for a year now there has been a trade war between the United States and China, which in the future threatens to seize other countries of the world. Donald Trump’s cabinet, loyal to the principles of America First, is trying to pursue a rather aggressive protectionist policy. However, all these efforts, including the introduction of a variety of duties, can be completely meaningless in the face of a strong dollar.

Meanwhile, the US currency now costs significantly more than on the eve of the 2016 elections – not least due to the consistent increase in rates in previous years. In turn, lower rates will open the way for a weakening dollar. The yield on American assets should decrease, which will prompt investors to invest their money abroad, which in turn will reduce the demand for the American dollar.

Thirdly, the global value of the rate may play an important role in the decision of the Federal Reserve. Europe is showing a strong slowdown, Mexico only miraculously escaped the recession in the second quarter. The Fed statement explicitly states the impact of global processes on the final decision.

It was given to the leadership of the Federal Reserve is not easy. The rate was reduced after a long debate in the Open Markets Committee, and at least two of its members disagreed, which happens not every time. Some believe that the decision was half-hearted, and that the rate had to be cut immediately by half a percentage point, others are sure that in the current situation there is no reason at all for easing monetary policy.

Donald Trump certainly belongs to the first camp: after the publication of the results of the committee’s debate, he attacked the Fed and personally Chairman Jerome Powell with criticism on Twitter. In his opinion, the rate was reduced hesitantly, and most importantly, Powell did not make it clear that he would continue in the same vein. “We win anyway, but certainly not with the help of the Fed,” he commented on the decision of central bankers in his usual style.

This Trump was supported by investors on world stock exchanges – the Fed clearly expected more. The American S&P 500 index fell by a percentage, almost all Asian exchanges except Tokyo turned out to be in the red. The paradox is that, despite the exceptionally high market quotes, traders still think that the Fed is holding the economy in gadgets.

Nevertheless, even such a modest decline is a good signal for leading emerging markets, including Russia. Not only that, in the face of falling American profitability, investors can be more careful about the opportunities to earn money in the “second world”, so the price of oil will certainly creep up. What is beyond the power of all crises in the Persian Gulf region, can be done in an instant by the inconspicuous central bankers in one solution. And if under pressure from Trump they continue to lower the rate, prices can easily beat the highs of recent years at 80–85 dollars per barrel.

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