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Why the Fed’s interest rate move matters

Federal Reserve building
Image copyrightREUTERS

The Federal Reserve, the US central bank, is expected to cut its main interest rates at a meeting in Washington on Wednesday.

US effective funds rate

Growth has slowed, though there does not appear to be an imminent danger of the economy actually contracting. That said, there have been some warning signs in the financial markets that often do signal a recession is not that far away.

The rest of the world keeps an eye on how well the Fed is managing to keep that balance between growth and inflation, since a healthy US economy reduces the risk of the rest of the world catching a dose of economic slowdown.

TV screen shows news of Fed interest rate cutImage copyrightEPA

What impact does the Fed have on currency markets?

Cuts in interest rates in any country tend to make its currency lose value against others.

That is because lower interest rates mean there is less money to be made by investing in that country’s assets, since they’re yielding less interest. Primarily that means government bonds.

If investors are less keen to buy, for example US government bonds, there is less demand for the currency needed to buy them. So the currency concerned, the dollar in this case, tends to lose value.

Currency movements affect how competitive countries’ exports are. If US rates are cut and the dollar weakens, American exports become cheaper, and imports to the US from elsewhere go up in price. That can have a knock on impact on the price of goods on shop shelves, in other words inflation.

But for other countries importing goods priced in dollars, the impact can be to reduce inflation. When the dollar is weaker it costs other countries less in their domestic currency to buy dollar-priced goods. And that’s not just American exports, lots of commodities including oil are priced in dollars.

What about the impact on international investment flows?

When an economy as large as the US changes its interest rates, it is possible for the subsequent movement of investment funds to be disruptive.

There was an episode in 2013 when the Fed started to consider reducing its quantitative easing programme. That programme involved creating new money to buy financial assets such as government bonds. Reducing QE was in some ways akin to raising interest rates.

The plan was to “taper” the quantitative easing, and the result for emerging economies such as India and Indonesia came to be known as the “taper tantrum”.

Large amounts of money left emerging market economies, and there were concerns at the time that it might even lead to a new financial crisis in those countries. In the event, that did not happen.

This time, because interest rates are likely to be cut, it is more likely that money will go into emerging economies. That can sometimes lead to financial instability (or unsustainable bubbles). That is not an immediate concern now, but it is a reason why governments around the world need to keep a careful eye on what happens in the US.

About Oluwadamilare Funsho

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