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          Faculty & Research

          Insights

          The US Federal Reserve on July 31st cut its key benchmark interest rate by a quarter of a percentage point, to a range of 2%-2.25%, in the first reduction in borrowing costs since a decade ago. It also ends its balance sheet reduction two months earlier than planned.

          Professor Tang Yao with the Guanghua School of Management pointed out that the move marked the end of the normalizing process of the U.S. monetary policy, potentially signaling an unprecedented change in the patterns of the U.S. monetary policy.

          Since 1980, the Federal Reserve has been gradually using interest rates as a key tool in its monetary policy, which is mainly driven by data — cutting interest rates amid low growth, high unemployment rates and low inflation, and vice versa. The financial market was very familiar with this pattern, and it helped the public reasonably predict the monetary policy of the Fed.

          As the data shows, the U.S. economy has been continuing last year’s steady growth. This growth is mainly driven by steady consumption while investment has been relatively weak. Its core inflation rate has been staying below the two percent target, and salary growth is not fast. Data-wise, the rate cut is not justified.

          During the interview following the rate cut announcement, Fed chairman Jerome Powell took on a flexible stance in a bid to give space for the Fed‘s decision-making. However, his attitude also made it hard for outsiders to gauge the Fed’s intentions. On one hand, Powell cited low return on capital, a weakening global economy, China-U.S. trade war, low inflation, amongst others, as factors contributing to the rate cut. Expected uncertainties were a major factor influencing the Fed’s rate cut decision, a sharp contrast with its usual practice to focus on real data and interest rates. On the other hand, he said the cut did not mark the start of a lengthy cutting cycle, stressing that future rate-related decisions will still mainly focus on economic data. He also ruled out that the move was in response to the pressure from President Trump, further baffling the market.

          Regardless of the logic and intention behind the rate cut, developed countries will face a low interest rate environment in the future. Currently, the EU and Japan’s monetary policies still center on negative interest rates. After the 2008 financial crisis, the Fed has been constantly increasing interest rates following quantitative easing. However, after this time’s rate cut, it only has two percent left, much lower than 4 or 5 percent, the usual amount of rate cut that is needed to cope with an economic downturn. Insufficient rate cut space means the country might have to resort to quantitative easing or even negative interest rates. Some Fed officials call for preemptive rate cuts to delay an economic downturn and avoid using abnormal monetary policy tools.

          It is hard to normalize a developed country’s monetary policy, and extraordinary tools such as quantitative easing and negative rates have been adopted more regularly, which means their monetary policy tool kit is already nearly exhausted. A combination of factors including slowed growth of total productivity factor, aging populations, income inequality and trade disputes will cause low growth and low return on capital in the future for a developed country. Without a structural reform to address these issues, cutting lending costs for investment and debts through monetary policy becomes the only game in town. Even in an economically sound country like the U.S., tax cuts in 2017 failed to greatly boost investment and its impact on consumption was also temporary. The burden had to fall on monetary policy.

          With pressures and expectations from politicians, the public and the financial market, a developed countries’ central bank is fully aware of the role of “savior” it plays and striving to upgrade and innovate their monetary policy. However, new policy might bring new risks. In the short run, relaxed monetary policy might reduce the risk of an economic downturn, but it will cause other risks to accumulate in the long run. For instance, low rates lead to a large amount of low rate and negative rate bonds, forcing investors to hold a great amount of high-risk bonds and stocks for higher returns. In terms of income distribution, the prosperity brought by low interest rates will worsen income and fortune inequality, hold back future demands and potentially cause new social conflicts.

          The rate cut not only ends the country’s rate hiking cycle, but might also open up a new era for its monetary policy, pushing the global economy into a macro-environment of more uncertainty. Following the rate cut, developed countries with space for rate cuts such as the U.K. and Canada will also go through more relaxed monetary policies. In such a global environment, China should more firmly push forward its supply side reform, make proper use of various policy tools to achieve moderate countercyclical adjustments and focus on ensuring high quality economic growth — instead of over-relying on relaxed monetary policy and other short-term measures.


          ? 2019 Guanghua School of Management Peking University

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