Fed Rate Cut and Its Impact On the UK

  • Oct 31, 2019 GMT
  • Team Kalkine
Fed Rate Cut and Its Impact On the UK

The past few decades of globalization have seen a sharp rise in cross- border capital flows as the world has become more financially integrated. These changes have brought to light two important roles the US financial system has come to play in the globalized economy. The United States financial system has increasingly become the primary producer and distributor of secure financial assets for the global economy. Second, the US central bank, the Federal Reserve, has become increasingly powerful to the extent that its policy stance provides direction to the policy makers of central banks across the globe.

The Bank of England has kept the lid on interest rates on account the deteriorating politico-economic climate in United Kingdom and continental Europe on account of Brexit-related uncertainties. The event which potentially can bring about large-scale business disruptions in the region has clouded the macro-economic climate of the region for the past couple of years. The consumer confidence and credit offtake of the country are at their lowest since the 2008-11 economic crisis and the banking and financial services sector, which contributes more 10 per cent to the British exchequer, turns out to be potentially the most impacted one as the expansions made in continental Europe in the past forty five years since United Kingdom has been a part of European Union, now stand to be disrupted.

This situation has been further exacerbated by the lingering trade war between United States and China, which now poses an external threat to the British Economy. The bank of England thus has no scope the increase the interest rates. The United States federal reserve, however, has come out and announced a rate cut on its own to deal with the global economic conditions itself. This has created a problem for the Bank of England who now faces the threat of excess liquidity in the markets. Overly stimulative monetary policy risks economic overheating, high inflation and asset bubbles in an expansive economy.

However, the rate cut decision of the US Federal Reserve was based on its own assessment of the country’s and the world’s economy. Since the first quarter of 2019, when projections of economic growth and employment were predicted to stay on course, it appears that they have slowed down from an elevated pace. Inflation, meanwhile,  has dipped slightly below 2 per cent again. Monetary policy works with a lag, and , it would be helpful to cut rates ahead of time if economic conditions were to deteriorate in the near future. Financial volatility in recent times has increased, and the Federal Reserve seems to be of the opinion that there are heightened risks to the economic outlook emerging from the slowdown in growth abroad and the potential for economic disruptions from uncertainties in trade policy.

Does this assessment of then Federal Reserve hold good for the rest of the world? Has its assessment taken note of the cross-border capital flows into the United Kingdom which already has a relaxed monetary regimen?  If there is an economic overheating, high inflation or asset bubble-type situation coming out of the United Kingdom or the rest of Continental Europe will have repercussions on the economy of United States. The build-up of different scenarios is very difficult to predict as the situation we are dealing with is extremely complex.

The economic outlook of IMF for the year 2019 and beyond is worth mentioning in this regard. They were not expecting a rate cut and also have a slightly better view of the world economy than the US Federal Reserve.  The Fund in its World Economic Outlook document published in April 2019 has postulated that the world economy will show signs of picking up during the second half of 2019. After a period of accelerated economic growth in 2018, 2019 started with a marked weakness with macroeconomic stress in Argentina and Turkey, the escalation of US–China trade tensions, disruptions in the automobile sector in Germany, tighter credit policy in China, and the normalization of monetary policy along with financial tightening in the larger and more advanced economies of the world have all contributed to a significantly weakened global expansion outlook. In response to the above developments, The Bank of Japan, The European Central Bank and The Bank of England have all shifted their focus to a more relaxed monetary stance. The outlook for the trade war between China and United States has improved with the prospects of a suitable trade agreement for the first phase looking bright. China on its part has also ramped up its monetary stimulus and fiscal policies in response to the negative effects of tariffs.

The economic growth of the world by 2020 is projected to return to the rate of 3.6 percent. The global rate of growth for next year and beyond will stabilize to around 3.5 percent, bolstered mainly by higher growth in India and China and their increasing importance in the global economy. This return forecast is on account of a rebound in Turkey and Argentina and improvement witnessed in other developing economies and in other stressed emerging markets and is therefore subject to considerable uncertainty.

The gap in the observations of the Federal Reserve and the IMF seems to be due to the timing of their observations. While the report of the IMF dated is April of 2019 the information and observations could very well be of January- February 2019. The Federal Reserve’s decision must have been based on information that is at least six months ahead of the IMF’s observations. This goes on to suggest that the world economic outlook has indeed deteriorated.

Considering the world’s economic outlook as a whole, the rate cut decision of US Federal Reserve seems to be appropriately placed. Until it creates real problems of economic overheating, high inflation and asset bubbles in United Kingdom and Continental Europe there is no reason to take a negative call on the Fed’s decision.

With Bank of England reducing the interest rates to a historic low level, the spotlight is back on diverse investment opportunities. 

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