Aug. 1, 2019
The U.S. Federal Reserve cut its key interest rate Wednesday for the first time since the financial crisis of 2008, marking the start of a new phase in monetary policy.
The central bank trimmed its target for the benchmark lending rate by 25 basis points to a range of 2 per cent to 2.25 per cent, a move that was widely expected given the spate of subpar data trickling out of the U.S. economy – and one U.S. President Donald Trump will be watching closely.
What does it all mean? Here’s a comprehensive guide.
Why did the Fed lower rates?
The Fed has a simple, if crucial, mandate: to maximize employment, maintain price stability and moderate long-term interest rates.
On the first two, some weak data has sparked concerns that the longest U.S. economic expansion on record is heading for a rough patch – if not an outright end.
So far in 2019, the pace of hiring has been lukewarm next to other post-recession years, and inflation is tracking below the Fed’s 2-per-cent target. Moreover, economic growth has slowed, and some key indicators – such as home sales and residential construction activity – appear to have topped out.
Meanwhile, the U.S. continues to wage a trade war with China and has yet to ratify a new North American trade deal.
Thus, many have dubbed Wednesday’s action as an “insurance cut” against a multitude of headwinds facing the U.S. economy.
In a statement, the Fed’s rate-setting committee cited “muted inflation pressures” and “global developments for the economic outlook” as part of its decision.
There were two dissenting votes in favour of no cut, while no committee members called for a deeper cut to 2 per cent.
Is the U.S. economy that weak?
Not really, and that’s why the Fed cut is a bit of a head-scratcher to some.
Yes, a handful of key metrics are slowing, but others are undoubtedly strong. Notably, the unemployment rate is close to a 50-year low, and consumer spending is robust.
That’s why, when the U.S. economy eventually sours, some worry the Fed will have limited room to cut and properly deal with a far graver situation.
“I think the Fed may be undermining its own credibility,” Megan Greene, a senior fellow at the Harvard Kennedy School and a former chief economist at Manulife Asset Management, told The Globe and Mail last week. “My worry is that the Fed is going to cut and it’s not going to do much to boost inflation or growth. That would leave it less prepared to face the next downturn.”
Is the Fed done cutting?
That remains to be seen.
Prior to Wednesday, traders of futures tied to the Fed’s benchmark rate had priced in a full percentage point of easing by the end of next year. And indeed, the Federal Open Market Committee said it “will act as appropriate to sustain the expansion," a sign that further easing is a possibility.
But during his press conference, Fed chair Jerome Powell also made it clear that a prolonged round of easing is unlikely.
“It’s not the beginning of a long series of rate cuts,” he said, but also added: “I didn’t say it’s just one [cut].”
As such, his comments aligned neatly with Bank of Montreal’s expectations.
“We believe that this will ultimately be a mini easing cycle, officially calling for just one more move in October,” said BMO Nesbitt Burns chief economist Douglas Porter in a client note prior to Wednesday’s decision.
Markets reacted unfavorably to Wednesday’s move. The S&P 500 dropped as much as 1.8 per cent before paring losses, driven lower by a more upbeat tone from Mr. Powell than market participants had anticipated.
“Markets were pricing in a much longer series of cuts,” said Avery Shenfeld, chief economist at CIBC Capital Markets, in a client note. “Equities won’t like this message [Wednesday], but might be happier if the Fed is right and the economy grows well enough to support gains in earnings in 2020.”
What exactly is this interest rate?
U.S. banks must keep a certain amount of cash in reserve. If a bank needs more money, it can borrow from another on a short-term basis. Borrowing takes place in the federal funds market. The cost of these overnight loans is known as the federal funds rate.
But the Fed doesn’t set this interest rate, per se. It does, however, have a target range. The upper bound of that range is now 2.25 per cent, with the lower bound at 2 per cent.
To ensure the actual lending rate – more formally known as the effective federal funds rate – falls within its target, the Fed buys and sells government securities to control the supply of reserves in the banking system.
If there are more reserves to lend out, for instance, rates will drop.
Why is this rate so important?
It is the fundamental interest rate in the U.S. and arguably the entire world, influencing the course of just about everything.
On a historical basis, the Fed’s key rate is quite low, despite the hiking cycle that played out from 2015 to 2018. Thus, mortgages, auto loans and savings rates are pretty low, too.
However, it’s worth noting that even though the Fed cut by 25 basis points (a basis point is 1/100th of a percentage point), that doesn’t mean all interest rates will fall an equivalent amount.
How does the President factor into this?
Mr. Trump is not a fan of high interest rates.
He has often implored Mr. Powell, whom he nominated, to slash rates in a bid to keep U.S. businesses competitive.
So, Wednesday’s move should make Mr. Trump happy, right? Maybe not.
Mr. Trump has often called for dramatically lower rates, so given Mr. Powell’s comments on Wednesday, the President could very well be disappointed.
What does this mean for Canada?
From a monetary policy perspective, Canada finds itself in a very different position from the U.S., along with other countries whose central banks have recently cut their policy rates or have signalled their intentions to do so.
Canada’s economic data, though not uniformly good, has often surprised in a positive way.
Consider the labour market. So far this year, the country has added almost 250,000 positions, the strongest pace to start a year in percentage terms since 2010. The national jobless rate, at 5.5 per cent, is close to its lowest point of the last four decades. Meanwhile, inflation is tracking close to the Bank of Canada’s target.
As such, Canada’s central bank is expected to keep its key lending rate at 1.75 per cent for the foreseeable future. Traders currently put the chance of a cut at September’s meeting at 10 per cent.
What about the Canadian dollar?
The Canadian dollar has performed remarkably well against its U.S. counterpart this year, relative to others.
In part that’s a function of timing: The loonie had a dreadful December but, prior to that, actually spent much of 2018 in a stronger position than today.
Still, the Canadian dollar has been helped by the greenback easing off its perch and the divergence in monetary policy, along with a strong run of domestic economic data. Many strategists expect ongoing strength, including French bank Société Générale, which has forecast the loonie hitting 80 US cents this summer.
But future Fed decisions will no doubt weigh on the loonie’s fortunes. The U.S. dollar rallied on Wednesday as it became clear the Fed won’t be cutting deeply.
With a report from Ian McGugan
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