By EI SUN OH
August 14, 2019
SOME good economic news that was not exclusively self-serving finally came out of the United States two weeks ago. The Federal Reserve, the US’ de facto central bank, finally decided to lower its policy interest after a stretch of more than two years of continuously hiking its globally influential rate.
Created slightly more than a century ago, the Fed is a uniquely independent governmental agency, distinct from the usual three branches of government — legislative, executive and judiciary. Consisting of a board of governors headed by a chairman, as well as the presidents of various regional federal reserve banks who are nominated by the US president and subject to confirmation by the Senate, the Fed is nevertheless not subject to the policy decisions of the executive administration of the day. It is only nominally subject to congressional oversight in the sense that from time to time its members would have to testify before or provide relevant information to Congress or the latter’s various committees.
Of course, the regulatory ambit of the Fed as a central bank would include enforcing financial laws passed by Congress, such as the slate of tightening financial regulations enacted after the global financial crisis a decade ago. But otherwise, the Fed’s most overt act of policy independence is none other than its aforementioned upward or downward adjustment of policy rate, essentially the interest rate with which it lends funds to financial institutions, decided every quarter or so after a much anticipated meeting of its federal open market committee. This rate adjustment would typically exert a ripple effect on not only the financial sector per se, but the economy as a whole, and not just in the US, but around the world too.
For financial institutions, such as commercial banks or credit unions, would typically operate on a profit-making motive. They do so by offering loans to businesses and consumers alike and charging interest on these. In order to make a profit, the interest rate charged would have to be higher than the interest rate with which the financial institutions borrowed from other sources, including the Fed. That is why typically in a commercial loan agreement, the provisions on interest to be charged would include a clause to the effect that the “real” interest rate would be the “baseline” interest rate (typically the Fed’s policy rate) at the material time, plus a certain percentage.
This is all well and done, except usually businesses would borrow to tighten themselves over a cash shortage or to expand their reach, while consumers borrow both to make expensive purchases such as housing and automobiles, and also sometimes to defray household expenses. If the interest rate charged is low, businesses would be keen to borrow more to expand, and consumers would also take out more loans to make purchases, thus stimulating the overall economic vibrance and spurring economic growth.
Conversely, if the interest rate charged is high, the business mood would of course be dampened, as businessmen would find the cost of doing business too high, and may delay business expansion or shut down business altogether. Consumers looking at increasing interest rates would also think twice before committing to spend their money. In either case, the economic vibrance is watered down, and economic growth is then of course put on hold. The Fed’s non-stop rate hikes over the past two years are alleged to have effectively put the brakes on the recovering US economy. And these allegations were made, among others, by none other than the US president, Donald Trump. Trump nominated the current Fed chairman, but has minced no words in his many Tweets about his disdain for the Fed’s independently made rate hike decisions in the past month. And even the latest Fed rate cut is apparently not perceived as enough by Trump as well as most market watchers, who all called for further cuts in the near future. Share markets tumbled as the news was announced.
The Fed is somewhat obsessed with maintaining an approximately two-percent inflation rate in the US economy through its monetary policy. Having operated through the Great Depression in the 1930s as well as the energy crisis in the 1970s, which saw skyrocketing inflation rates in double digits, the Fed is determined not to let the inflation rate run wild, lest it destroy the fruits of economic achievements like in many a South American country. On the other hand, the Fed is economically sanguine enough to realize that a moderate degree of inflation is needed to provide incentive for businesses to grow. If a business is forever charging a few cents for its goods, then it might as well close shop after a while as profit margin thins out. So the Fed has over time settled on 2-percent inflation as its policy target. There is nothing magical about this, but just a policy preference of the Fed as it observes and participates in the US economy over time.
But this obsession with a somewhat controlled inflation rate can be a double-edge sword, as I have argued previously. For better or worse, the US dollar and the American capital it entails not only floats along in the US domestic markets, but flows into the rest of the world too, including the so-called emerging markets. A Fed rate hike attracts more repatriation of American capital from overseas, as well as the outflow of overseas domestic capital into the US, as the “safe haven” effect of American markets becomes ever more alluring. This would not only deprive the emerging markets of much needed capital, but would also jack up inflation in the US markets, as more “hot” money is now available for commercial speculations. And this latter phenomenon of course defeats the Fed’s much avowed inflation stabilization effort. Conversely, when the Fed lowers its interest rate, it is also sending a perhaps unintended signal to the rest of the world, that those capital parkers there could stay put for the time being, until such time as the Fed initiates yet another cycle of rate hikes in the future. And these are precious moments for the capital-starved emerging markets.
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