Fed Cuts the Base Interest Rate to Historic Zero Percent

The Fed’s move is an unprecedented precedent, as most central banks still have room to cut given that most interest rates are now around two percent, although this mainly applies to Europe. Markets more directly tied to the dollar and the American economy follow the Fed’s moves like Japan or Hong Kong, which has cut its rate to half a percent.

Written by: Vanja Figenwald
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Many traditions have been broken in recent months, infamous records are falling and being created, and the latest in a series of shocking news fits perfectly into otherwise exciting times for the economy. The American central bank, the Fed, cut the base interest rate last week for the tenth time in recent months. By itself, this would not be particularly fascinating news if it weren’t for the entirely new context. Now that rate stands at a ridiculous 0.25 percent in the worst case, and in the best case, exactly 0! The rate, therefore, is not fixed and, quite clearly, is the lowest in history.

In addition to this historical aspect, however, there are also other dimensions of such a decision. Such a move, in fact, definitely confirms recent statements by the head of the European Central Bank, Jean-Claude Trichet, that mass and continuous interest rate cuts could go to the opposite extreme, which could have a counter-effect. Furthermore, this move shows the increasingly dire situation and points to the uncomfortable truth that monetary authorities are truly running out of ammunition for short-term effects and that the fiscal branch must urgently get involved with quick and effective solutions as things could become very ‘hairy’ in the coming months. Holger Schmieding from Bank of America reinforces this: – What will be the next step for regulators now, when they cannot cut the rate further?

The entire crisis has shown the incredible stubbornness of the modern economy. All previous attempts to kickstart an almost completely stalled economy are not yielding the desired results; on the contrary, things are stubbornly slowing down even more. Of course, the stock markets immediately reacted positively to the Fed’s decision, recording jumps of 4.20 percent (Dow Jones), 5.14 percent (S&P 500 index), and 5.4 percent (Nasdaq). This is a small consolation, however, considering that recent stock market drops and jumps do not mean much when it comes to the real economy.

Interest Rate Cuts Everywhere

Other central banks also reacted immediately, following the step from America. Thus, the Czech central bank lowered its base interest rate by half a point, bringing it to 2.25 percent. The same story is true on the other side of the world, in Japan. The Japanese central bank has cut interest rates for the second time in two months. The overnight rate has been reduced to a completely symbolic level of 0.1 percent, although it was already at 0.3 percent. The yen immediately plunged against the dollar, prompting speculation about direct government intervention in the exchange rate to prevent further strengthening of the yen, which largely depends on Japan’s export capacity, one of the engines of growth.

Interest rates had already entered the anthology a few weeks ago when the European Central Bank cut the rate by three-quarters of a percentage point to 2.5 percent, a move followed by the central banks of Sweden and England. However, the Fed’s move is an unprecedented precedent, as most central banks still have room to cut given that most interest rates are now around two percent, although this mainly applies more to Europe, while other markets, more directly tied to the dollar and the American economy, follow the Fed’s moves like Japan or Hong Kong, which, for example, cut its rate to half a percent, while Kuwait and Norway, on the other hand, are currently at 3.75 percent and have a much wider maneuvering space.

With all these desperate attempts to ‘grease’ the economy, the question arises where all that money is disappearing? Because with or without a crisis, with or without a collapse of financial markets, all the money has not simply evaporated overnight, so the real question is why these injections are not felt in the economy, or why lending and the circulation of money have not been initiated. The answer, it seems, is eluding everyone for now, although the closest to the truth is that frozen by fear, everyone is holding onto their cash, both banks and companies. How serious the situation is is reflected in the fact that the Fed intends to further expand its range of options with additional unconventional measures. Simply put, having exhausted the bullets in the old gun, it will buy itself a shotgun. This means a longer-lasting symbolic interest rate and the continuation of the purchase of toxic assets to cleanse the market polluted by the greed and irresponsibility of several financial institutions.

Fiscal Solutions Are Next

Strong and, for bankers, extremely unusual aggressive statements are yet another new element that should certainly be noted as they serve a very concrete purpose. The Fed’s statement included, among other things, the following: ‘The Federal Reserve will use all available instruments to promote the restart of sustainable economic development and maintain price stability.’ The fundamental problem of the global economy at this moment is the almost complete loss of trust among participants in the economic process, so such statements should be understood in that sense. It is not at all unimportant to send a clear and radical signal to the market, even if there are not sufficiently strong resources behind it. With such an expansion of credit programs, the Fed’s balance sheet has grown from below $900 billion to over $2 trillion, but further growth is expected, up to $3 trillion according to some estimates.

The greatest victim of the current upheavals is undoubtedly trust and the willingness of participants in the economy to continue as before, after many have been burned so badly that they can no longer look like they did before. The situation, although very difficult, has not yet reached catastrophic proportions as some like to believe, but it must be realistic and admit that it is no longer just a cinematic possibility but a very real one, in case the blood flow does not soon resume. The task facing economic decision-makers is not that difficult, actually. The accumulated knowledge about the economy and experiences gathered over a long time show that one cannot really go much further than the already known solutions. In other words, what is known, is known. Everything that the Fed thinks to add to its portfolio of operations, therefore, is not, nor can it be revolutionary. The monetary branch is nearing the peak of its capabilities, which, brother to brother, have never been as wide as those in the hands of politics, i.e., the fiscal branch. A series of fiscal stimuli that the governments of major world economies have devised in recent weeks will be, it is now clear, crucial for any potential exit from the pit. Beyond that, there is actually nothing else.