The US interest rate cut game soon? Sri Lanka to benefit or struggle?

 

Article's Background

• From the beginning of this year, markets have been speculating on the commencement of the Fed's rate cut cycle to ease its monetary policy. The basis is the inflation reaching around 2% target from its peak of 7.1% reported in June 2022.

• However, the Fed consistently communicated that it had not gained the full confidence on inflation sustainably falling to the 2% target to think of a policy reversal.

• However, the Fed Chairman at the Jackson Hole Symposium held on last 23 August clearly signaled that the time has now come to dial back the policy (Read the speech here).

• The next monetary policy meeting is due on September 17-18. Markets speculate at least 50 bps rate cut at the next meeting and 100 bps rate cut by end of this years. Bank of England and European Central Bank have already started rate cutting cycle with initial 25 bps cut followed by Bank of Canada.

Therefore, the purpose of this article is to highlight the nature of the Fed's rate cutting cycle that can be expected and its implications on emerging market economies in several years to come.

Fed's monetary policy objectives

According to the Fed Act, "The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

However, the Fed only communicates its goals as the price stability and maximum employment. Therefore, it frequently talks about risks on the balance between price stability and maximum employment.

Price stability is defined as 2% target of the annual increase in personal consumption expenditure prices within the consumer price index. However, while there is no target for maximum employment, unemployment rate is closely monitored to establish how it deviates from its natural rate version generally around 4%.

Further, the Fed never talks about the goal of moderate long-term interest rates or long run growth of the monetary and credit aggregates for economy's long-run potential to increase production.

Further, the goal of moderate long-term interest rates is contravened as interest rate is exclusively used as the independent policy instrument for goals. Therefore, the US economy never experiences in moderate interest rates. Nobody is worried about the goal-instrument conflict.

In addition, financial stability is not specified in the Fed Act as a goal. However, the most part of the monetary policy such as emergency lending and and liquidity auctions is driven for keeping the financial stability.

The signal communicated by the Fed Chairman

His speech at the Jackson Hole Symposium contained following information to signal that the Fed is now ready to commence the rate cutting cycle.

• "The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks."

• "My confidence has grown that inflation is on a sustainable path back to 2 percent."

• "It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions."

However, he has clearly conveyed a conditional signal as usual, but the commencement of policy shift in the near-term has been clearly indicated.

Fed Chairman's evidence for the policy shift

The Fed Chairman provided convincing evidence in both verbal and graphical modes as highlighted below to establish that the economy has now evolved to accept lower interest rates for the balance between price stability and maximum employment which are two statutory objectives of the Fed.

Graphical Evidence

• Inflation Trend

• Unemployment Trend

• New Employment Trend

• Policy Rates Trend

Verbal Evidence

• In the environment of record policy tightening as shown by the rate hiking cycle, inflation has fallen towards 2% while labor market has started cooling as shown by unemployment risen to 4.3% with new job openings gradually falling.

Fed's key data points considered in making the interest rate decision are the annual inflation rate, unemployment rate and new job openings to the unemployed. 

Accordingly, the Fed now believes that the balance between price stability and maximum employment is achieved by the policy tightening during the past two years with soft landing. Its view now seems that the continuation of the tightened policy is to result in a hard landing with a higher rate of unemployment and considerable recession.

Background for the presently tight monetary policy

The policy tightening has been exclusively used for the control of three decades high inflationary pressures confronted by the US since mid-2021. The high inflation is a result of demand-supply disruptions and imbalances caused by the Corona pandemic in 2020 and 2021, excessive fiscal and monetary stimulus implemented to fight the pandemic impact and the increase in global energy and commodity prices caused by the Russian-Ukraine war since February 2022.

A summary of historic monetary and fiscal stimulus implemented to tackle the pandemic impact is given below.

Monetary front

• The increase in the Fed balance sheet by US$ 4,766 bn from US$ 4,173 bn at the end of 2019 to US$ 8,939 bn by April 2022 (i.e., an increase of 114%).

• Policy rate cut by 1.5% from 1.50%-1.75% in January 2020 to 0-0.25% in March 2020 and continuing till March 2022. 

Fiscal Front

• The US Government implemented several extra spending legislations from the CARES Act in 2020 to the present Inflation Reduction Act in 2022. The total spending amounted to US$ 7,318 bn. The expansion of the Fed balance sheet through the purchase of Treasuries at zero bound interest rates also helped fiscal spending. In addition, more than 100 bn worth special military aid was offered to Ukraine and Israel. 

The Fed Chairman's speech has given a fine narrative of how the economy has evolved to three decades high inflation from the pandemic hit and come back to strong growth momentum with low inflation.

In this background, the Fed's monetary tightening since the end of 2021 covered a reduction in its balance sheet to US$ 7,140 bn so far (i.e., a reduction of 20% US$ 1,529 bn) and a speedier hike in policy rates by 5.25% to 5.25%-5.50% and keeping it at that level for the past 13 months.

Since the US currency/monetary system is about 27% fractional reserve system (reserve money/money supply ratio), the Fed interest rate and balance sheet policy has a significant impact on the US financial and real sectors as well as on the global economy.

International transmission and effects on Sri Lanka

The Fed balance sheet is already high at US$ 7,140 bn to keep policy rates at high 5.25%-5.50%. Nearly 60% of Fed liabilities or assets is now held in bank reserve accounts with the Fed and earns interest through printing of money. 

Therefore, the speculated rate cutting cycle requires further expansion of the Fed balance sheet in order to inject more reserves to the monetary system for keeping interest rates lower. Therefore, both US economy and global economy will flood with new dollar reserves providing immense opportunities for a new round of growth and human development.

The US Dollar is the most popular reserve currency representing nearly 60% of global reserves. Therefore, any change in the US monetary policy entails a quick global transmission. The primary root of the transmission is the global capital flows.

In times of the US monetary tightening, other countries also raise interest rates to keep interest margins and retain foreign capital from the US. However, the stance of other countries is mixed in response to the US rate cuts in order to benefit from the capital outflow from the US.

• Developed market economies are able to adjust their policies to keep pace with the US policy.

• Emerging market economies with favourable BOP and foreign reserve positions also can manage the impact by adjusting monetary policies in line with the US.

• However, emerging market economies with protracted trade deficits and monetary systems dollarized through debt-financed-foreign reserve become miserable because they are not free to cut interest rates competitively due to several reasons.

• First, the frequency and duration of the speculated US rate cutting cycle is not clear. In general, given the fact that the present hiking cycle has been there for nearly two and half years, it might take more than three years of rate cutting cycle. Remaining price pressures above 2% inflation target and geopolitical tensions in both US economy and global economy are not supportive for any fast reduction in policy rates. Therefore, the risk of rate cuts fueling the US economy already with strong growth and low unemployment to overheat the economy is considered very high. In that context, the Fed will move only very slowly based on incoming data on a meeting by meeting approach.

• Second, unlike in rate hiking cycles where emerging market monetary policies too will follow suit, they will tend to hold already high interest rates at present levels to compete for foreign capital flowing out from the US.

• Third, this monetary policy strategy will not work for countries like Sri Lanka who suffer from debt and foreign currency crisis because capital will not flow to these countries due to heightened country risks. Therefore, investors will tend to continue in the US being a strong growth economy for the safety.

Therefore, economies of countries like Sri Lanka will continue to confront prevailing high interest rate regimes in anticipation of foreign capital inflow to help continue the dollarized monetary system. Some countries are de-facto currency board systems. Therefor, their monetary policy game has essentially been for the maintenance of the dollarization. 

As a result, these countries will struggle in long recession for many years in the global economy with relaxed monetary policies in the developed market economies. The IMF programmes and consultants will only help temporarily tinker the foreign reserve problem and dollarization in these countries with hot capital out of new global reserve glut and monetary relaxation expected in next few years. 

This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures. All are personal views of the author based on his research in the subject of Economics which have no intension to personally or maliciously discredit characters of any individuals.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 12 Economics and Banking Books and a large number of articles published.