US Fed rate cut: Need to be watchful on forex side if it is beginning of further interest reductions

The reduction in interest rates by the Federal Reserve was expected and hence there was apparently no surprise element. There has been relentless nudging by US President Donald Trump and it was felt that the political push to Jerome Powell may have been the last straw which made the rate cut more or less given and signal more in the coming months. In fact, some expected a more aggressive rate cut of 50 bps because this was something the US president had spoken of for being effective. However, the Fed went with 25 bps and the rate is now 2-2.25 percent. If this explanation is kept aside, how should one view the rate cut by the Fed as it is a very important signal for other central banks too given the wider implications for the rest of the world.

This rate cut comes after a decade and hence a change in the stance of the central bank which had first stopped and rolled back the quantitative easing (QE) before increasing rates to the region of 2.25-2.5 percent. Normally rate cuts in the US have been associated with recessionary conditions but the economy is one of the better-performing ones notwithstanding the slowdown in Q2.

Unemployment is at a low and hence it is not that jobs are a problem. Inflation is low at 1.6 percent and can be an explanation albeit a weak one as rarely does the low price syndrome become an ‘end in itself’ for the Fed. Another interpretation provided is that the rate cut has more to do with preventing any slippage in the Gross Domestic Product (GDP) growth and hence is a preemptory measure invoked keeping the future in mind. It is more likely that the Fed has looked at the issue of growth from the global standpoint and based on its assessment decided to go for a cut for a larger purpose. The International Monetary Fund (IMF) also sees world growth declining this year. The message is that there could also be more cuts coming in course of time and the asset (bond) rollback policy has also been terminated two months earlier. However, the Fed chairman has been equivocal on this aspect of ‘more cuts’ by terming the stance to be accommodative meaning thereby that anything was possible. [caption id=“attachment_4510271” align=“alignleft” width=“380”] File image of Federal Reserve Board Governor Jerome Powell. Reuters.[/caption] What does this mean for the world? A lower rate in the US means a weaker dollar as the signal is that the economy is not that strong which in turn will put other currencies under pressure as appreciation will be the order. This was a problem earlier too for India when the dollar weakened as the mirror image is a stronger rupee which affects exports. But the final result will also depend on how other developed countries’ central banks react. If all choose to lower rates, then the equilibrium will not be affected. Second, lower rates in the US also make investors a bit jittery and look for other avenues and emerging markets can stand to gain. Here, it would be interesting to see if they continue to flow to India in the aftermath of the Budget where FPIs moved out of equity. The Indian government may have to reconsider some of the proposals with regard to the FPIs if we are to leverage this development. In the past, a weaker dollar which went with a weaker US economy, made investors explore other markets. The current situation will have a weak dollar and a not-so-weak economy and hence could have different outcomes. Third, as the US decision is also based on a weaker world economy, this means that global trade will be lackluster and to this extent, there will be impediments for Indian exporters. Typically, exports are related strongly with global demand driven by growth and less to currency changes. Therefore, there is a reason to believe that Indian exports growth would be impacted by these developments. Fourth, on central bank action, the Reserve Bank of India (RBI) has always maintained that monetary policy action is driven by domestic issues relating to inflation and while it does read what other banks are doing, the final driver is Consumer Price Index (CPI) inflation. This being the case, there is little reason to believe that the Fed rate reduction will directly affect the monetary policy committee’s (MPC) decision on 7 August. However, when it comes to other central banks, there is a belief that there tends to be some relation between their actions and that of the Fed. Lowering of rates by the Fed will reinforce the decision taken by the European Central Bank (ECB) to continue to do all that is necessary to revive growth. Similar actions may be expected by the Bank of England (BOE) and Bank of Japan (BOJ). In a way, one can also draw a conclusion that the current state of economy of the US is not as confident as it was earlier and that the trade war with China and the imbroglio with Iran added to uncertainty even though there has been no deep impact so far. But clearly, the Fed believes that the global economy is in a state of flux and some decisive action was required on its part. If it is a one-off rate cut, it may not matter, but if it is the beginning of further rate cuts, then we would need to be watchful especially on the forex side. (The writer is chief economist, CARE Ratings)