The last time the U.S. Federal Reserve's Federal Open Market Committee cut interest rates, the global financial crisis was in its early stages, Beyonce’s "Single Ladies" topped the Billboard 100 list and George W. Bush still occupied the Oval Office. On July 31, more than a decade after that last loosening of monetary policy, the Fed announced a cut of 25 basis points in the federal funds rate. The decision was driven by several factors, including an increasingly dim outlook for global economic growth, further signs that U.S. inflation is softening and, of course, relentless pressure on the central bank by U.S. President Donald Trump to deliver a rate cut.
The Fed’s decision will cascade across the world as other central banks feel pressure to match its moves in dealing with their own slowing economies. However, fears of a global currency war set off by a series of rate cuts are overblown. Nevertheless, Trump’s concerns about the dollar’s relative strength and overvaluation will continue to push an aggressive U.S. policy toward countering perceived currency manipulation.
The Federal Reserve’s short-lived period of quantitative tightening is apparently over, given its announcement of a cut in the interest rate target by 25 basis points. The timing of the rate cut is unusual because of the strength of the U.S. economy, but signs of increasing sluggishness in the global economy and growing pressure by U.S. President Donald Trump drove the Fed's decision. The cut will add pressure for other central banks to follow suit.
The Fed Cut in Context
As Stratfor laid out in its 2019 Annual and Third-Quarter forecasts, global economic growth continues to slow. And concerns among economists, politicians and investors that the trend will only continue have endured. In its World Economic Outlook released July 18, the International Monetary Fund (IMF) reduced its 2019 global growth projections by 0.1 percentage points to 3.2 percent. Such a global environment has weighed heavily on countries with heavy dependence on exports, like Germany, where economic growth is expected to fall below 1 percent. At 0.5 percent in the first quarter of this year, global trade growth was the lowest it had been since 2012.
Of course, the Federal Reserve’s focus is on the U.S. economy and environment. The Fed has struggled to reach its target inflation rate of 2 percent — as of June, it sat at just 1.6 percent, year-over-year. The U.S. economy, however, while cooling, still grew at an annual rate of 2.1 percent in the second quarter (its weakest performance since the first quarter of 2017). In fact, despite continuing to downgrade global growth expectations, the IMF boosted its forecast for U.S. growth in gross domestic product by 0.3 percentage points to 2.6 percent. However, it still expects that measure to slip to less than 2 percent in 2020 given the effects of trade jitters and the drop off of the stimulus effects that were generated by the 2017 tax reform. In short, while the U.S. economy is looking as if it will slow a bit from its current state, the Fed's rate cut can be seen as a proactive attempt to soften the blow. Besides, the move could provide a cushion against the possibility that U.S. trade battles will escalate, with more tariffs being implemented.
Political Turbulence Continues for the Fed
In all likelihood, the forces moving the Fed to act do not appear to be easing soon. Trump is entering an election cycle and U.S. economic performance under his watch will be a key pillar of his 2020 campaign message. Indeed, at 121 months and counting, Trump is now presiding over the longest economic expansion in modern U.S. history. Any significant downturn in economic growth — particularly a rise in unemployment or a decline in the stock market — that would weaken Trump’s message could lead him to chastise the Fed for not being proactive enough in cutting rates.
Perhaps more significant, however, there are few reasons to expect a reversal in concerns about global trade. U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin’s trip to Shanghai to discuss trade issues have merely been presented as a reset and level-setting of talks between the United States and China. Any progress on trade negotiations is likely to continue to be extremely slow, with a reasonable chance of a breakdown as both sides pursue their harder-line demands. A breakthrough in trade talks — if one happens at all — may not occur until early 2020 and a trade deal might happen only after the United States increases tariff pressure on China. The external force of trade pressure would add more weight to China’s own sluggish economic growth figures in the coming months.
Beyond China, some signs have emerged that the United States and Japan could quickly complete and sign their trade deal, with Tokyo desiring to avoid the chance that Washington will slap more tariffs on Japanese goods. But across the Atlantic, the chances that Trump will open a full-blown trade war with the European Union — or at least with France — are increasing. The United States has lamented the lack of progress of trade talks with the bloc, especially over its unwillingness to include agriculture. Indeed, EU Trade Commissioner Cecilia Malmstrom noted July 23 that the talks had hit a stalemate. The lack of progress does not bode well for the European Union’s desire to avoid tariffs on its auto exports, which could be announced after Nov. 13, the date when a U.S.-imposed six-month deadline for imposing auto tariffs expires.
The aerospace sector represents another battleground where an EU-U.S. trade war could play out. The United States has suggested that it could subject a list of EU goods representing as much as $21 billion in annual trade to tariffs as a result of a dispute involving European subsidies to aircraft manufacturer Airbus. This involves a case working its way through the World Trade Organization (WTO), which is currently deciding how much damage the subsidies inflicted on the United States. The European Union expects the total to be on the order of about $7 billion. The European Union has pursued a similar case against the United States involving financial support to Boeing. Finally, on July 10 the Office of the U.S. Trade Representative announced that it had opened an investigation under Section 301 of the Trade Act of 1974 on a French proposal to levy taxes against large tech firms — almost exclusively American. If the investigation determines that France is treating the U.S. companies unfairly, the Trump administration could hit French goods with additional levies or subject French citizens and companies in the United States to extra taxes.
Several other brewing issues could also wreak havoc on global trade. Although Mexico has been able to avoid Trump's threatened tariffs over Central American migrant flows to the United States, the issue could resurface in the coming months if the White House tries to pressure Mexico City to sign a legally contentious "safe third party" agreement that would prevent large numbers of migrants from reaching the U.S. border with Mexico. And according to some indications, the United States has also been exploring a potential Section 301 investigation on India. Added to those pressures are possible U.S. actions at the WTO. U.S. intransigence could push the WTO's appellate body to gridlock later this year, and it has potentially laid the groundwork to target certain countries that benefit from a self-designation as developing, a status that gives them preferential treatment. South Korea, Mexico, Turkey and others could be affected by this push.
The First Cut Is the Deepest
Needless to say, the White House will continue to pursue its confrontational trade strategy. And in many countries in the line of fire, the combination of the Fed rate cut and increasing trade pressure coupled with their own weak economic growth prospects will push their central banks and economic policymakers in the direction of further monetary easing and fiscal stimulus. Even those countries not affected by U.S. trade policy will have to follow in the Fed's footsteps to keep their currencies stable relative to the dollar. The end of the U.S. quantitative tightening program in September will only add momentum to U.S. monetary easing efforts.
It will be difficult for President Trump to intervene directly to push the dollar’s value lower, particularly in an election year.
Central bank rate cuts have become the norm this year. Since the start of January, there have been just 12 interest rate hikes globally (four of which were made by Pakistan as part of ongoing talks with the IMF for a bailout). Comparatively, there had been 20 combined over just the last two months of 2018 as the Fed wrapped up its tightening cycle.
In a rate decision announced last week, outgoing European Central Bank (ECB) President Mario Draghi declined to cut interest rates but softened the ground for a cut at the bank's next policy meeting on Sept. 12. But unlike the Fed, the ECB is already in negative interest rate territory. Even though it could cut its deposit rate, which sits at minus 0.4 percent, by a tenth of a percentage point, there is little room for it to push further into the negative. Because of this, the ECB will almost certainly at some point augment its monetary easing strategy with a renewed quantitative easing program. An ECB interest rate cut could also be put on hold until October after Christine Lagarde takes the bank's helm.
Over the next few weeks, several key central banks are scheduled to hold policy meetings, and a few could match the Fed’s moves. Both Australia and New Zealand’s central banks hold meetings on Aug. 6. At each of its previous two meetings, the Reserve Bank of Australia cut interest rates, which sit at a record low of 1 percent. While markets don’t expect another cut just yet they are pricing in another by the end of the year. The Reserve Bank of New Zealand, however, is a near-lock to cut rates for the second time this year.
The movement toward monetary easing is not unique to the developed world. Shortly after the Fed's announcement, Brazil cut its rate by half a point, more than had been anticipated. Ahead of India’s central bank meeting on Aug. 7, markets have fully priced in a cut in interest rates. Over the past month, Azerbaijan, Indonesia, Russia, Turkey and South Africa have all cut interest rates. Nigeria's bank is expected to also announce a reduction.
For Washington, those moves create a bit of a dilemma. From an economic standpoint, monetary easing policies are designed to generate growth in sluggish economies, but all things considered, they increase deflationary forces in currencies, even if that is not their explicit intent. This can generate export-oriented economic growth, but it will alienate a White House looking at ways to combat an overvalued dollar. Trump will almost certainly tweet his concerns about currency-weakening moves — particularly by the European Union and China — as being unfair to the United States.
The Prospects for Currency Disputes
The IMF handed Trump more ammunition on the currency front this month when it released its annual External Sector Report. For 2018, the IMF estimated that based on purely economic fundamentals, the U.S. dollar was overvalued by between 6 and 12 percent. Conversely, for Germany, the IMF found that the euro was undervalued by 8 to 18 percent. Despite an economic argument backing his point, it's not clear how far Trump is willing to go to aggressively counter other countries' currency values and actively weaken the dollar.
While a de facto currency war pursued through interest rates and monetary policy is unlikely because most central banks in the developed world don’t have the Fed’s flexibility in cutting rates, the Trump administration will still try to pick at the issue around the margins. Politically speaking, it will be difficult for Trump to intervene directly to push the dollar’s value lower, particularly in an election year. Robust U.S. consumption — fueled in part by the strong dollar — has buoyed the economy's performance this year despite the global slowdown, and any moves to considerably weaken the dollar will affect that.
Nevertheless, White House trade adviser Peter Navarro has reportedly pushed for the administration to use the Treasury’s $94.5 billion External Stabilization Fund to weaken the dollar — a plan that Trump has rejected, for now. The Treasury Department traditionally uses the fund in coordination with the Fed and other central banks. While it is certainly possible that Washington could try to broker an agreement like the 1985 Plaza Accord, under which the United States worked with other countries to push down the dollar's value, other countries would likely reject that idea in the current climate, given the potential effect on other global currencies and their policies. The United States could tap the fund without coordination, but it's unclear how effective a unilateral plan would be in weakening the dollar over a sustained period.
It's most likely that any action the United States might take on currency issues would include more superficial measures and narrowly focused investigations. Trump has already pushed for trade deals to include currency clauses, and the Treasury Department has broadened the criteria it uses to designate a country as a currency manipulator. Functionally, neither approach has significant teeth, but another, stronger one may be developing. In May the Commerce Department announced that in some cases it would consider “undervalued currency” to be an export subsidy, allowing complaints to be filed under antidumping and countervailing duties proceedings. Thus far, no cases using this criterion have emerged, but it is clear that the Trump administration wants to put currency issues at the forefront of its trade policy.
There's no doubt that the Fed’s interest rate cut will have global ramifications and was undertaken in part as a result of the global environment. While the decision is not a case of direct intervention to reduce the value of the dollar, that could happen nonetheless. In any case, as the Fed now enters a potential easing cycle, it will be critical to watch how far it goes. After all, this saying still holds: If the Fed sneezes, the world catches a cold.