n its first interest rate cut for a decade, the US Federal Reserve (Fed) lowered its benchmark rate by 0.25 percentage points, setting the target range from 2 percent to 2.25 percent for its overnight lending rate on July 31. The global market reacted drastically and in an unexpected way. The stock market in Europe and the US nosedived, followed by a global selloff. Prices of US Treasury bonds also fell by 5 percent. Normally, yields of long-term US Treasury bonds, which reflect long-term market interest rates, are higher than yields of short-term bills, which reflect the short-term market interest rate. However, the opposite happened, and some are now arguing that it is a precursor of economic recession in the US.
The gap widened even after the Fed’s rate cut. It reflects market pessimism about the US economy, and a lack of confidence in the Fed’s monetary policy. I believe that on the one hand, the rate cut indicates rising uncertainties in global economic growth and monetary policy. On the other, the Fed’s rate cut will spur a wave of similar actions across the globe. Both will again lead to adjustments to financial policy and global markets.
After the 2008 global financial crisis, the world economy has been growing at a low to medium rate. It fell sharply after the crisis and did not see a strong rebound until 2010, and then growth slowed gradually. Economic growth in 2018 was 3.7 percent, while average growth between 2009 and 2018 was 3.41 percent, a decrease of 1.07 percent from the average of 4.48 percent between 2000 and 2007 and lower than average growth in the 30 years before 2008.
The year 2018 marked a peak in the growth over the past 10 years after the global financial crisis. But growth will continue to decline, as economic activities slow in the business cycle and the stimulus measures from every economy draw to a close. It is predicted that in 2019, global growth will drop to 3.3 percent and further decrease to 3.2 percent between 2020 and 2022. Developed economies will feel a more obvious slowdown. The average growth of developed economies was 2.65 percent between 2000 and 2007. Between 2009 and 2017, growth nearly halved by 1.26 percent to 1.38 percent. The growth is predicted to continue to slide for developed economies between 2020 and 2022, to around 1.8 percent for the US, 1.3 percent for Europe and to less than 0.7 percent for Japan. The global economy again is entering a low-growth stage.
The US economy will continue to slide. Since early 2019, household spending has been robust with continuous growth, which has driven growth in the US economy. But demand from the external market is slowing. Meanwhile, due to uncertainties over US domestic and foreign policies, enterprises are cautious in making decisions about their capital spending, and the growth in investment spending continues to slow.
Federal Reserve Chair Jerome Powell stated in the subsequent press conference that the Fed’s decision to cut rates “ was appropriate” to sustain the economic expansion. It reflects that the Fed has already noted the economic slowdown.
When I worked at the IMF between 2011-16, the US was one of the countries under my watch. We conducted systematic research about the potential economic growth of the country and found it was 2 percent.
Stimulated by US President Donald Trump’s tax cuts, 2018 saw robust growth in the US economy. But growth will eventually fall to the potential 2 percent. Between 2020 and 2022, growth will fall below 2 percent thanks to the fading effect of excessive fiscal stimulus and the prolonged trade war. The downside risks that Powell mentioned include trade frictions, the Fed’s debt ceiling, Brexit and weak global growth, including the slowdown in Europe and Asia. These
factors will stay for another two to three years and underscore the uncertainties in global growth.
In 2007, the financial crisis triggered by sub-prime mortgages in the US began to emerge and rapidly spread to other markets, including bond and stock markets. As an emergency intervention, from September 2007 the Fed started to cut rates, first by 50 basis points to 4.75 percent. As the situation worsened, the Fed continued to cut rates to drive domestic demand and stimulate the economy and eventually lowered it to a range between 0 percent and 0.25 percent on December 16, 2008.
The low rates continued until the US economy started to recover, when the Fed announced a raise of 25 basis points in December 2015. Since then, the Fed started a regular rate-raising cycle to leave room for a loosening policy to handle the next crisis. On December 19, 2018, the Fed increased rates by another 25 basis points and the rates were raised to a range of 2.25 percent-2.5 percent.
In January, the Fed began considering to make a U-turn from the current trend to cope with the worsening global economic prospects and other risks that may jeopardize economic growth, implying that it would patiently adjust the rates. On June 20, the Fed decided to hold the rates unchanged, but assessments from the Federal Open Market Committee, the Fed’s decision-making body, showed signs of a rate cut for the first time. While cutting rates continually, the Fed also adopted quantitative easing measures in the aftermath of the 2008 financial crisis to stimulate economic growth. It started to purchase massive amounts of Treasury bonds and mortgage-backed securities backed by the government to keep market rates low and stimulate the economy, which expanded the Fed’s balance sheet.
From the end of 2008 to October 2014, the Fed put forward four rounds of quantitative easing programs, expanding its holdings from US$900 billion before the crisis to US$4.5 trillion. As economic performance improved, Janet Louise Yellen, then chair of the Fed, announced a halt to the purchase of bonds and securities in October 2014, and the balance sheet has been kept around US$4.5 trillion since then. Starting October 2017, the Fed officially started regular reductions in the size of bonds and securities it holds on its balance sheet. By July 31, 2019, its holdings were reduced to US$3.6 trillion.
The recent rate cut indicates that the Fed’s cycle of cutting and raising rates following the 2008 financial crisis has come to a sudden stop. It is entering a new stage which is appropriate for rate cuts, but it will be marked by uncertainties.
The varied reaction from the US stock, bond and currency markets reflects their bewilderment. Rate cuts are supposed to relax monetary policy. On the contrary, it has tightened monetary policy in effect. Powell said at the press conference that the cut was a “midcycle adjustment” instead of a prelude to a longer rate-cutting cycle. It shows the cut was unconventional. The market, surprised by Powell’s statement, downgraded its forecast about how many times the rate would be cut in a year, which was already priced into the stock market, to a state of uncertainties. This resulted in a sharp fall in stock markets and a widening spread between short-term and long-term Treasury bonds. However, the dollar was weakened, as expected in orthodox economic theories.
I mentioned on several occasions that there is a high probability that the Fed might cut rates once this year, or possibly twice, but not three times. But the market almost unanimously predicted it to be three times. The fall in the stock and bond markets, which was beyond all expectations following the Fed’s recent rate cut, demonstrates clearly the market’s adjustment to the previous overshot prices following Powell’s statement.
On the other hand, the Fed’s rate cut causes uncertainties because Powell listed uncertainty in foreign trade as one reason behind the cut, somehow binding together US monetary policy and US President Donald Trump’s trade war. This may expose the Fed to moral hazards.
There have already been questions over the necessity of cutting rates. Even though growth in the US economy slowed in the second quarter, which was mainly because of weak investment due to the trade war, growth in consumer spending remained strong. Now that the Fed made a rapid connection between monetary policy and trade wars, the neutrality and impartiality of the Fed will be questioned. This will also affect the effectiveness of the cut, regarding to what extent it can transmit the change to the market.
Powell’s statement indicates that the Fed will be ready to make a quick response at any time, particularly when facing an economic downturn. It shows that the Fed has officially dropped its previous way of setting monetary policy that mainly guided the market before taking action since the 2008 financial crisis. It is shifting to a mode that depends on data and making quick and flexible decisions according to changing situations. This will inevitably lead to divergence and fluctuations in the market’s forecasts and interpretations of the Fed’s monetary policy. Potential US economic growth is around 2 percent, which is decided by its economic structure after the crisis. The Fed’s monetary policy will not change that. The US economy will continue to slow, back to around 2 percent, and in the process, it inevitably will fall to even below 2 percent. It is not realistic to rely on the preemptive action of monetary policy to lift economic growth above the potential.
The global economy, 10 years after the financial crisis, is in an unconventional post-cycle stage. An environment featuring moderate economic growth and steady low inflation rates is taking shape. Liquidity remains abundant, but global uncertainties are rising and market confidence is fragile. The trade war, Brexit, universal fiscal vulnerability and sharply rising geopolitical risks are affecting the confidence and decision-making of the market, companies, central banks and governments constantly. The US Fed’s rate cut suggests that the global economy is entering a new post-crisis period, with uncertainties and fluctuations.
Compared to 2008 when the financial crisis broke, the US economy is in relatively better shape in terms of economic growth, employment and the inflation index. But government debt continues to soar, the stock market runs high and so economic performance will constantly fluctuate. In this situation, the Fed’s monetary policy will sway between rate rises and rate cuts. The uncertainty in the Fed’s monetary policy mainly affects the financial markets and adds uncertainty. On the other hand, the rate cut this time, which started from 2.5 percent, was quite different from the ones around 2008, which started from 5.25 percent in 2007 and eventually went down to nearly 0. This left limited room for further cuts. When cuts are made randomly, the influence will be limited too.
Since the 2008 global financial crisis, given the quantitative easing monetary policies worldwide, liquidity is generally loose in the US stock markets and global financial markets. In the short term, the loosened liquidity will remain unchanged overall as the economy maintains modest growth and inflation remains low. The Fed’s cuts also show that it will keep liquidity loose. The Fed’s cut will lead the central banks worldwide to cut rates, and subsequently set a trend of low rates globally.
Entering 2019, in expectations of the Fed’s rate cut and the actual cut, more than 20 central banks worldwide cut their rates. India cut rates three times before July, showing both uncertainty in its economic growth and a preemptive response based on worries over the Fed’s rate cut.
For emerging economies, rate cuts will lead to a weaker dollar, and capital will flow out of the US market. In 2018, against rising political risks and a sluggish economy in the eurozone and Asia, the global financial situation tightened and the dollar appreciated. The quarterly average portfolio investment in emerging markets reduced to less than US$17 billion in 2018 from US$31 billion in 2017. In 2019, following the change in monetary policy, the portfolio flowed back to emerging markets, rebounding to US$36 billion. If rates continue to drop, more capital will flow in and further elevate the stock market in emerging markets, which no doubt will aggravate the risks and fragility in the global financial market.