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One rate cut good, three rate cuts bad

One rate cut good, three rate cuts bad

November 8, 2019

Two weeks ago, the Federal Reserve cut its benchmark rate for the third time this year in an attempt to curb a slight slowdown of the economy. Afterwards, officials signaled that this could be the last cut for the time being.  With a strong jobs report from October and international trade pressures keeping investors happy, some are questioning if the rate cut was really necessary.

With trade so uncertain these days, it is reasonable that the Fed would want to cushion the impact. Bruising trade wars like the one America is in right now have serious adverse effects on the economy for the same reason as any other tax: it depletes private markets of private capital for the enrichment of the government.

This means that businesses will likely have to borrow more to cover the extra costs of any imported products that they need. Lowering the benchmark rate helps keep interest rates low for these borrowers and keep the economy running smoothly when headwinds like tariffs hit.

However, three rate cuts in one year is hard to justify, especially since hiring has been cruising at a such healthy clip and unemployment has been at historically low levels. While low rates do help bolster borrowing, higher rates make America more attractive for foreign investors seeking higher returns than what can be found in other developed economies, such as the Eurozone and Japan, where rates are ultra-low or even negative.

Three rate cuts are also inappropriately punishing savers who have had to put up with near zero savings rates at retail banks since the beginning of the 2008 financial crisis.

Punishing savers for the benefit of spenders is not sustainable in the long run because there needs to be cash deposits from savers to lend out in the first place. If there is no incentive for people to save, banks are going to find themselves running a lot closer to the lower limits of capital adequacy standards.

These capital adequacy standards are essentially the bare minimum amount of cash banks have to have on hand in case people want to withdraw their savings or unexpected loans come due. Banks run into trouble when they lend too much  because then they can run the risk of not being able to meet people’s withdrawal requests. This is called a run on banks.

Another drawback of easy money central bank policy is the buildup of excess debt due to unsustainable levels. Current levels of U.S. corporate debt are setting records. Total corporate debt was at $15.5 trillion dollars in July 2019, 74% of the national GDP.

These levels are unsustainable and will cause the economy to crash and burn in the long term. Unfortunately, low interest rate environments incentivize this type of excessive borrowing. Taking on worrying levels of debt looks like no problem to a lot of businesses when they can finance operations for less than 3% of their profits.

Business discretion with debt has gone out the window since 2008, and now we have an entire generation of corporate finance managers who have come up in a decade of easy money without having seen firsthand the effects of a recession. In this case, both the Fed and businesses bear this responsibility. If already leveraged businesses were smart, they would take the time to pay down their debt and take advantage of these low rates to do so.

Despite these criticisms, Jerome Powell does deserve a lot of respect since taking over the Federal Reserve. It is likely one of the hardest jobs in the world, and with so many different economic indicators pointing every which way possible, the job he’s done so far is admirable.

Debt can be a powerful tool to businesses and individuals, but if you abuse it, it will always abuse you right back in the end.

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