Updated: Aug 6, 2020
This time last week, central banks around the world gathered to decide on whether to change their base interest rate, the rate at which the reserve lends money to banks. The importance of this figure cannot be underestimated, as it is the rate that determines the pricing of all other assets, as well as being a key dictator of the health of the economy. While the Bank of England decided to keep the Base Lending Rate for the British banking system steady at a historical low of 0.75%, other international central banks globally were not being so firm.
The U.S Federal Reserve Chairman, Jerome Powell, announced this week that the Fed’s overnight funds rate will be cut by 0.25% to bring the rate to between 2 and 2.25%. With the European Central Bank also taking a stimulative approach to its monetary policy by maintaining its main refinancing rate at 0%, and even going as far as to imply resumed expansion of its bond buying program, it is clear that central banks around the world are keen on applying a more stimulative approach in influencing the world economy.
The Federal Reserve’s meeting was an incredibly influential moment in the global economy due to the U.S dollar’s position as a global reserve currency. The decision to cut rates was deemed necessary by the Federal Committee as a pre-emptive action in the face of slowing global growth and the mounting possibility of a recession in the near future. It was a pivotal moment, yet highly-contested by market analysts, as it was the first time in history that the U.S Central Bank chose to cut interest rates with total unemployment figures below four per cent, and the economy expanding at an all-time high. Those in favour of the rate cuts contend that the large divergence in rates between the United States and the rest of the world would lead to an increase in the price of the U.S. Dollar, as has been seen in recent years. This discrepancy has become more pronounced and come to hurt U.S exports and multinational’s profits. Similarly, they argue that since the real interest rate, (the interest rate after accounting for inflation) is still much higher than the developed global average, bonds represent an attractive comparable investment.
On the other hand, those against the rate cut find that its attempts to inoculate the U.S economy from any downside effects of a global slowdown are merely postponing the problem until a later date. Continuing to lower interest rates before a slowdown will leave less room to manoeuvre when the downturn comes, and injecting more liquidity into the system in the tenth year of the longest expansion in history will prolong the inevitable, leaving the Federal Reserve with less tools at its disposal for the next time that they are needed.
In conclusion, with such a strong economy, some market participants have wondered about the motives for such a change and worry that the U.S will follow suit with many other countries and regions across the globe, where a turn to negative rates has hurt savers and bond investors. As much as 50% of all European government bonds have a negative yield, meaning that investors are paying the bond issuer to take their money. This causes tremendous problems for long-term investors in pension funds and endowments, who now have to invest in much riskier assets in order to meet their return requirements or lower their projections greatly.
What do you think? Do you think cutting the interest rate is a good decision? Let me know your thoughts below!
Also, here are some great resources to learn more:
About the Author: Ross Fehily is a Third Year Business Management student at the University of Birmingham. He currently works as a Corporate Finance Analyst for Orbis Partners as part of his course. Though he specialises in TMT and Business Services sectors as part of his job, he has a keen interest in economics, finance and all kinds of markets.