Reasons for the Fed Rate Cut and How It Will Affect Canada

For the first time since the global financial crisis of 2007-2008 the Federal Reserve cut US interest rates at the end of July. The announcement followed President Donald Trump’s unexpected announcement of additional tariffs on $300 billion of Chinese imports. The US has, in effect, now added tariffs on every Chinese import not already taxed.

The Fed typically cuts interest rates when a recession threatens. The idea is to stimulate economic expansion. Lower interest rates encourage borrowing and investment, and thus accelerates economic growth.

Right now, there appears to be little evidence that the US economy is slowing, so what does the Fed know that the man in the street does not?

Chairman of the Federal Reserve, Jerome Powell called the action a “mid-cycle adjustment”. It may be that the action was taken to reverse what could have been over-zealous upward rate adjustments in 2018.

At this stage, the US domestic economy is strong, and according to Mr Powell, it should keep expanding. He said that the rates cut was intended to strengthen the economy against what he called “downside risks”. This suggests that he sees the cut as a sort of insurance against the chance of a future economic downturn.

During a news conference following the rate adjustment, Mr Powell struggled to articulate the bank’s strategy or tell the listeners what would signal future rate cuts at a time when there appears to be relatively little risk of a recession in the US.

He did however state that this is not the beginning of a long series of cuts.

The Longest Economic Expansion in Us History

The Fed was hiking rates just seven months ago. A rate cut normally signals the Central Bank’s concern with the economic growth in the country. In this instance Powell has said that the bank is happy with the current growth in the US economy and that the rate cuts were in response to sluggish global growth and growing trade friction.

After 121 months of economic growth, the US is experiencing the longest economic expansion in its history. The unemployment rate, at 3.7%, is the lowest it has been in nearly fifty years. Even marginalised and unskilled people can find employment in this environment.

The impact of the trade wars and the tariffs imposed on European and Chinese goods could however negatively affect manufacturing in the country with resultant job losses. A number of companies have put their plans of expansion and investment on hold as a result of the tariffs.

Entrenched Low Inflation

Entrenched low inflation in the US is another concern for the US Fed. In the last year consumer inflation has risen by 1.6%, below the Fed’s target of 2%.

Mr Powell has made it known that he is concerned that the US could end up with the kind of low inflation scenario that plagued the Japanese economy for years. Low inflations negatively affected consumer spending and economic growth in that country for years.

Lowering interest rates may help to put some pressure on inflation. It is also the chairman’s stated intention to keep economic expansion on track so that unemployment can continue to benefit the poor and disenfranchised.

Many had hoped for a for a 50-basis point move rather than the 25-bps cut announced by the bank. The target range is now between 2% and 2.25%. This is the first rate cut since December 2008 following the global financial crisis. At that time the rates were slashed to close to 0% and stayed there until 2015.

The central bank made no commitments to further decreases. President Donald Trump was quick to throw insults at the bank regarding the size of the cut. What the president wants is an aggressive series of rate cuts. Trump’s ongoing criticism of the Fed could undermine the people’s confidence in the ability of the bank to remain independent especially before next year’s general election.

Many people wonder whether the interest rate movement will do much to bolster an economy where there is very little borrowing. Others feel that the bank should hold back on rate cuts as it may need some monetary policy weapons in its arsenal if the US economy does slide into a recession.

How Does the Cut Affect Canada?

The Bank of Canada has made it clear that Canada is on its own economic path. It has no plans of following the Fed and cutting rates in Canada. Many people may be surprised that the BoC is going its own way, as there is a perception that it always follows the Federal Reserve.

The central bank is currently satisfied with both inflation and the pace of economic growth in the country. There appears to have been a rebound in manufacturing and the growth rates for the last three months have been better than expected.

Growth is tracking to reach 3%, considerably better than the BoC expectation of 2.3%. Producer Price Increases fell by 1.4% in June, the biggest fall in almost two years. Raw materials dropped by a staggering 5.9%.

Unemployment rates are at near record lows having added 250,000 jobs to the economy since the beginning of the year.

While Canadian borrowers may not see a rate cut anytime soon it is unlikely that they need fear a continuation of the rate increases that they endured last year.

US interest rate cuts will put upward pressure on the Canadian Dollar, so any further rate cut in the US may force the BOC to reduce the rates in Canada. Economists expect that rate cuts in Canada will only happen in 2020.

The Canadian Dollar could continue to strengthen as investors may view the Canadian economy as stronger than the US economy. The strengthening dollar will support higher commodity prices. This is because commodities are priced in US dollars.

When the dollar drops, demand for commodities increases as the relative prices drop. The problem is that a strong Canadian dollar could affect exports as the goods become more expensive. If this happens then economic growth could slow down.