Central banks, via monetary policy, ultimately aim to influence domestic financial conditions which in turn affect economic variables like growth and inflation. Interest rates are only one component of aggregate financial conditions, but probably one that central banks influence the most directly.
The other major components of this include relative currency strength, credit spreads, and equity markets. In a phase of same direction policy moves, this ability to maintain or ease relative financial conditions via monetary policy action ultimately decides whether such action has been successful or not.
The US Federal Reserve
With the Fed cut yesterday, major developed market central banks have officially begun the process of easing that some of their developing market counterparts have already embarked upon earlier in the year. Thus, the above framework of gauging policy effectiveness via relative changes in domestic financial conditions (of course, relative to domestic economic and stability conditions) is a useful way of both monitoring effectiveness of easing, as well as in trying to predict the future path of easing for the particular central bank.
Going in, the messaging around the Fed rate cut was going to be tough to execute. This is because the US economy by itself, although slowing, is prima facie merely reverting to its more sustainable trend rate of growth of around (or just under) two per cent from the fiscal stimulus fuelled trend of around three per cent last year.
The consumer is doing well and unemployment rate is very low. Enough jobs are being added, thus far, to maintain these low levels of unemployment. Under such circumstances, it was always going to be tricky for the Fed to conform to the market’s expectations of multiple rate cuts without a somewhat bleaker assessment of the economy. This kind of an assessment may then have caused damage via the confidence channel. More fundamentally, it may genuinely not be in consonance with the Fed’s honest economic assessment.
Under the circumstances it did the best it could, justifying the cut on the basis of the global slowdown (particularly in Euro and Chinese manufacturing), trade related uncertainties, slower than desired US inflation, and a somewhat lower than earlier estimated so-called neutral policy rate. Within US growth dynamics as well, there is a recognition of the slowing manufacturing and business investment part of the economy.
In the press conference post the meet, the Fed Chair described the cut as a mid-cycle “insurance” cut in order to make sure that the recovery prolongs in the face of global and trade related headwinds and also to give support to inflation. In particular, he was focused on the cumulative change in financial conditions since early in the year during which the Fed has turned from being on a hiking cycle, to being on a patient hold, to finally cutting rates by 25 basis points (bps).
Indeed, when looked at this way, and remembering some of the major components of aggregate financial conditions, while over this period the US dollar hasn’t done much, interest rates are substantially lower, credit spread expansion late last year has been arrested and equity markets have largely held. Thus, it could be argued that financial conditions have loosened in the US over the past few months, thus helping to sustain the recovery — a point that the Fed Chair mentioned more than once.
The problem, of course, is with respect to forward guidance. After a long time, there is next to none, barring an impression given that the market shouldn’t expect a series of cuts. If the somewhat underwhelming Fed meet yesterday leads to incremental significant tightening of financial conditions relative to strength of incoming US data, and given the prospective actions of other central banks, then it is likely that markets will start leading the Fed again. This, if it happens, will be evidenced in a resumption of curve flattening.
The European Central Bank (ECB)
As against the Fed, the ECB is facing a more dire economic situation and, it may be argued, has potentially a weaker tool kit to address it with. Thus, both growth and inflation have turned for the worse and there are important potential negative events on the horizon, including the effects from a potentially ‘hard’ Brexit. he need for action is, thus, clear and some of it has already started in terms of guidance and proposed resumption of long-term refinancing operations.
The main deposit rate for ECB, however, is already negative and there are some constraints to further meaningful expansion of quantitative easing (some of which may be surmountable via court rulings). There is obviously the related question of the incremental utility of further quantitative easing (QE) expansion. This is because at least one major intended outcome of QE is to bring down long term rates. But in a world where large swathes of long-term rates are already near zero or indeed negative, one wonders how far this effect of QE has to run.