The rate cut by the US Federal Reserve (US Fed) is significant for
four reasons. The first is that it was widely expected and hence was a not a
surprise. In a way, it is a victory for President Donald Trump (the $1 trillion
tax cut has not quite worked?). The second is that it comes after 10 years,
which is a fairly wide hiatus and could be the beginning of another rate cut
cycle. The third is that the cut has been invoked at a time when there is no
recession or any sign of it, and even though the economy has slowed down from
3.1 per cent in Q1 to 2.1 per cent in Q2, the unemployment rate is healthy (at
a 50 year low) and inflation is close to the 2% target. Fourth, for the first
time, it appears global concerns of slowdown have also played its role.
The reason for such a cut ostensibly seems to be to secure the
future growth path, or what is being called an ‘insurance cut’ to ensure that
it should not be affected due to interest rates being high. This sends a
positive signal to the developed world in particular, as in a way it induces
other central banks to pursue such policies. With the US-China trade standoff
still to be resolved and with Brexit also in limbo, a cut in rates should help
to assuage sentiment.
Lower interest rates not accompanied by a recession do not signal
that there is a slump in the world economy, and hence, global trade should not
be affected to begin with. However, if the US economy does start to slip in Q3
further, then the implication would be that conditions are going get harder.
The International Monetary Fund (IMF) has already signalled lower growth in the
world economy though US is still projected to be at 2.6%. As ECB has also
signalled easing further, this can be read in tandem as good news for the markets.
What about the dollar?
A rate cut cycle means a weaker dollar, which is good for the US
but may not be so for the rest of the world. It has been seen in the past that
as the dollar weakens due to lower growth tendencies, the rupee has tended to
strengthen which will pose a conundrum for us as exports will come under
pressure with a double whammy – slower demand due to lower global growth and a
stronger rupee. This will not be good for the current account deficit (CAD).
However, normally a weak US economy with lower rates tends to move
investors away to other markets, especially the emerging ones, and this is
something that has brought in the dollars for us. This is where the aftermath
of the Budget should be put in context because there has been an exodus of FPI
flows from the equity market post July 5th. The question is whether or not we
will be able to bring these flows back.
Also, the view of the Monetary Policy Committee (MPC) will be
important because if the decision is to keep lowering rates, the difference in
yields will diminish thus blunting the edge that the Indian market offered.
Lower interest rates and a weaker dollar also means stronger gold,
as the metal will continue to shine under such circumstances. From the Indian
point of view greater investment demand for gold can surface putting pressure
on a pressurised trade deficit. Therefore, there will be more volatile
conditions in the markets for sure which we have to be prepared for.
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