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.
Madan Sabnavis is chief economist at CARE Ratings. Views expressed are his own