Economic downturn and interest rate cuts

The fear is growing that the global economy is moving towards further slowdown if not into recession. The key areas of the global economy are contracting. The British and German economies contracted in the second quarter of this year and the Italian economy remains flat. The US also is experiencing a fall in business investment coupled with a fall in industrial output. Argentina, Brazil and Mexico economies are in the throes of recession. Argentina is now also in need of an International Monetary Fund (IMF) bailout, has introduced currency control and is rescheduling repayment of short-term bills held by institutional investors and longer-term debt. All these countries are members of G20.

Businesses are now figuring out how this overhanging cloud of business uncertainty is being resolved rather than undertaking new investment decisions. In an uncertain economic environment, it is too risky to invest in new plants and equipment. Furthermore, trade and tariff risks complicate companies' decision as regards to where they should build their next plant or to organise their supply chain. That calls for careful economic policy making which will not undermine business confidence. Continuing with short-term policy adjustments does not help much to boost business investment in the real economy because most business investments are medium- to long-term decisions. If businesses refrain from investing for a longer period, that will cause weaker demand. And in turn that will feed into further slowdown in economic activity.

The central banks of the industrialised countries are now responding by lowering interest rates or announcing such policies. But the European Central Bank (ECB), Bank of Japan (BoJ), Sweden, Denmark and Switzerland are all already sitting on negative interest rates. However, risks include economic slowdown in China, uncertainties caused by the US-China trade conflict and increased prospect of a hard Brexit along with political instability in Italy and general pessimistic economic outlook in the European Union (EU) and other industrialised countries. These factors are further adding urgency to introduce impactful monetary policy package rather than tinkering with it. There are also longer-term risks such as the breakdown of rules-based international trade and issues relating to climate change.

The measures under consideration appear to be more of the same: further cuts in interest rates and a resumption of asset purchases, even after the ECB had previously decided to phase it out. By all indications it appears that it will be a very large scale operation.

ECB president Mario Draghi on September 12, announced a package of measures to stimulate the ailing Eurozone economies. This includes a cut in interest rates further into the negative zone. In fact, the ECB's central rate has been in the negative territory for the last five years. In addition to cutting its benchmark interest by 10 basic points to -0.5 per cent, the ECB has also announced to reintroduce a massive quantitative easing (QE) programme starting on November 01, the day Christine Lagarde is expected to move into Draghi's office. The plan calls for the ECB to spend as much as US$22 billion a month buying bonds from Eurozone countries "for as long as it takes'' until the purchases start to boost inflation rates. The ECB has persistently undershot the inflation target at 2.0 per cent since 2013, so the stimulus package is seen as essential to maintain its credibility. The ECB emphasised that interest rates would continue to stay at the present or lower levels until the outlook for inflation "robustly'' converged to its goal of just below 2.0 per cent.

The rate cut increase the cost of commercial banks to hold their excess reserve - whether for a potential acquisition, or investment or as cushion against an economic downturn. Many leading banks are complaining that the rate cut has put enormous financial burden on them as they are forced to absorb most of the cost of negative rates. A charge on the overnight deposits at the central bank by commercial banks is one such cost, because they can not be easily passed onto ordinary customers. However, the ECB said it would compensate for part of the charge to ensure they continued to lend money to the real economy. The ECB also eased its longer-term loan facility to banks and would introduce multi-tier deposit rate scheme to ease the financial burden arising from the new deposit rate as a way to cushion the blow.

But Draghi's plan has been opposed by central bank officials in Germany and Netherlands. They fear that such a stimulus package may encourage bubbles. But Draghi took his fight to Germany, Netherlands and other fiscal disciplinarians and said "Now it is time for the fiscal policy to take charge'' and further added "Fiscal policy should become the main policy instrument''. His successor Christine Legarde also expressed the similar view to European Parliamentarians and said "Central banks are not only game in town'' and governments with "the capacity to use the fiscal space available to them'' should fork out cash on infrastructure.

However Draghi's critics point out that the Eurozone's big problems are mostly exogeneous arising from Trump's trade war, Brexit and slowdown in the Chinese economy which are beyond the control of the ECB. But these factors do create business uncertainty impacting on corporate profitability. Thus, the stimulus package will have very limited impact and more importantly, interest rate cuts and cheap money no longer help if corporate profits collapse.

The ECB's decision infuriated US president Donald Trump, who urged the Federal Reserve (Fed) to aggressively cut interest rates below zero and complained "They get paid to borrow money, while we paying interest''. He also tweeted "they are trying and succeeding in depreciating the Euro against the VERY strong Dollar, hurting US exports …..And Fed sits, sits and sits.''

And that prompted a swift rebuttal from Draghi, who insisted he was simply following his mandate and the mandate is to pursue price stability and not target exchange rates. But the Euro did collapse following the rate cut decision with prices crashing towards US$1.0930 against the Dollar before later recovering over US$1.1000.

But on Wednesday (September 19), in what is surely a complete coincidence, the Federal Reserve, given its much vaunted political independence, did cut its benchmark fund rate by quarter of a percentage point getting it down to 1.75 to 2.0 per cent range. This is the second cut since July this year and they hint that there might be one more before the year is over. Even such an extraordinary action of the Federal Reserve was too little for President Trump, who wanted even bigger rate cuts. Trump reacted to the news with another tweet that Federal Reserve Chairman Jerome Powell and his institution "Fail again. No "guts'', no sense, no vision! A terrible communicator''. But many observers believe his lobbying the Federal Reserve to lower interest rates in the US is motivated by the desire to perk up the US economy ahead of next year's presidential election. Also many point out that his desire for zero interest rates will lead to an unpredictable and dangerous asset price bubble.

In the US economy, household consumer spending is the most significant component of gross domestic product (GDP) on the expenditure side, almost close to 70 per cent. Any slump in consumer spending will have very significant impact on the US economy. Consumer confidence will play a major role in stimulating consumption expenditure. The escalation of tariffs would put a dent into that confidence. Federal Reserve Chairman Jerome Powell in his opening speech laid the blame for much of the current economic trouble in the US on trade policy. He also mentioned that trade policy tensions are creating uncertainties causing negative impacts on investment and exports. Such remarks clearly indicate the limits of monetary policy alone to achieve economic objectives under the current economic environment.

Muhammad Mahmood is an independent

economic and political analyst.

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