What You Need to Know About the Fed’s Interest Rate Cuts

On March 15 the US Federal Reserve announced that it will slash interests rates to zero to cushion the American economy from the impact of the coronavirus pandemic. This will put interest rates in the range of 0 to 0.25 percent down from the range of 1 to 1.25 percent. Among those who applauded the move was president Donald Trump who said “That’s really great for our country. It’s something that we are very happy, I have to say this, I’m very happy.”

The Fed’s Goal: Prevent a Recession

The move by the Fed comes just days after UK’s Bank of England cut interest rates and the Chancellor of the Exchequer introduced a stimulus package to shield the economy from descending into a recession inspired by the coronavirus pandemic.

The Fed’s announcement came hot on the heels of Goldman Sachs’s revelation that the US economy would shrink by 5% in the second quarter after zero gross domestic growth in the first three months of the year. This will be as a result of businesses and consumers cutting down spending. The eventual outcome according to Goldman, would be a serious recession.

Earlier before Goldman’s warning, US Treasury Secretary Steven Mnuchin downplayed the possibility of the economy descending because of coronavirus, even though he admitted that the economy would slow down as businesses shut down temporarily. “Later in the year, obviously the economic activity will pick up as we confront this virus,” Mnuchin told ABC.

Although some people among them President Trump have long urged the Fed to reduce rates further to negative, Jerome  Powell the chair of the Board of Governors of the Fed ruled out this saying, “we do not see negative policy rates as likely to be an appropriate policy response here in the United states.” Instead the Fed will try to maintain zero percent rates until US economy comes out of the coronavirus instigated economic crisis.

The Central Bank Crisis Playbook: Cut Rates, Then Cut Them Some More

Reducing interest rates to encourage spending has long been the favored by Central Banks in responding to threats of deflation and recession. Lower interest rates means its cheaper for families and businesses to borrow money thus promoting investment and spending. This could be a family spending money on holiday or buying a new car, or it could be a company building a new factory. For instance during the 2008 global recession the Bank of England quickly lowered Bank Rate from 5% to 0.5% to prop up the UK economy.

However, it reaches a point where normal market operations aimed at lowering short term interest rates become ineffective especially when the rates are at or approaching zero. In this case Central Banks will switch to a new policy to boost economy by buying a certain amount of assets. This policy is known as Quantitative Easing or simply QE.

QE is described as a process whereby a central Bank such as the Bank of England or the Federal Reserve purchases existing government bonds in order to inject money directly into the financial system .

“A large scale purchases of government bonds lower the interest rate or yields on those bonds,” says the Bank of England. “This pushes down on the interest rates offered on loans (eg mortgages or business loans ) because rates on government bonds tend to affect other interest rates in the economy.”

What Does Quantitative Easing Accomplish?

QE mainly achieves two goals. First it makes it cheaper for businesses and households to borrow money, in order to boost spending and investment. Secondly, it can stimulate the economy by boosting a wide range of financial asset prices. Quantitative easing is normally a last resort to stimulate spending in an economy when interest fail to work because they have reached minimums.

For instance because interest rate cuts announced are at about zero, the Federal Reserve also introduced a QE program under which it will buy $700 billion worth of bonds as part of its plan to shield the economy from the impact of coronavirus. Of the $500 billion of the $700billion will be US Treasury bonds while the rest will be mortgage-backed securities to stabilize home loans.

Wall Street Reacts to the Fed’s Decision

Wall Street financial experts gave varied opinions on the new measures introduced by the Federal Reserve.
“Well, if this doesn’t work, the Fed will presumably do even more QE, provide more explicit forward guidance, and perhaps experiment with target credit measures and the like. I find it hard to believe that any of those measures .. will work if today’s actions don’t, however,” said Eric Winograd , senior vice-president and US economist at AllianceBernstein told Business Insider.

“Broad fiscal spending and rate cuts are blunt instruments for dealing with short term economic impact of the virus , but should provide investors with some confidence that growth can be strong once the recovery gets underway,” said Mark Haefele, chief investment officer at UBS Global Wealth Management.

Chief market analyst at Avatrade Nadeem Aslam told CNN that this is the Fed’s biggest card to play, “The world is facing a pandemic situation this extraordinary time, we need extraordinary measures. The Fed cutting the interest rate to zero and restarting the quantitative easing package is the biggest nuclear bazooka.”