Fed Funds Rate Slash

The US Federal Reserve recently suppressed Fed Funds Rate to a near-zero level (0.25%). With consistent rate cuts, the Fed Fund Futures turned negative with speculators foreseeing negative interest rates in FY 2021.

This speculation came after Donald Trump suggested the Federal Reserve to implement the “gift” of negative interest rates to kickstart the shrinking economy. While the Federal Reserve has denied the idea of negative interest rates, speculators and investors are still convinced about the possibility of interest rates reaching sub-zero levels, as early as May 2021.

So, what is Fed Funds Rate? And how can it affect the interest rates?

Every bank is legally obliged to keep a certain percentage of deposits they receive from customers with the Central Bank. In the USA the central bank is the Federal Reserve, in India, it is the Reserve Bank of India (RBI). Some banks might have excess reserves while some might be facing a reserve deficiency. The Fed Funds Rate is the rate at which banks lend their excess reserves to help fulfill the reserve requirements of other banks. This lending is done on an overnight basis.

The Fed Funds Rate plays a pivotal role in determining interest rates across the US Economy. Any change in Fed Funds Rate reciprocates to the general public in the form of subsequent changes in credit card interest, mortgage rates, auto loans, etc. An increase or a decrease in this rate can increase or decrease interest rates to end consumers, thereby, vastly affecting the economy.

Why did the Federal Reserve slash the Fed Funds Rate?

The US economy has drastically contracted during the ongoing pandemic. With barometers of economic development showing signs of concerningly low growth (or even negative growth) and the speculation of an impending recession, the Federal Reserve had no option but to systematically reduce the Fed Funds Rate to boost the economy.

Through the Federal Funds Rate slash, the Federal Reserve aims to stimulate 4 interlinked aspects of the economy:

Availability and Cost of Credit
Private Consumption
Inflation
GDP and Exports

1. Availability and Cost of Credit

An increase in Fed Funds Rates implies expensive lending for banks which are short on reserves, therefore, incentivizing these banks to limit credit and fulfill reserve requirements. This increase in reserve lending rates also forces the bank to increase interest on credit extended to its customers to maintain profitability.
A decrease in Fed Funds Rates enables banks to fulfill reserve requirements at a cheap rate, therefore, incentivizing these banks to increase credit and maintain lower reserves. This decrease in reserve lending cost helps the banks to lower interest on credit.

To conclude, a low Fed Funds Rate increases the volume of credit in the economy and simultaneously makes borrowing more affordable.

2. Demand and Private Consumption

Private consumption is essentially the value of goods and services acquired and consumed by households in the economy. It is directly related to demand. Due to the current COVID-19 crisis, demand for non-essential goods has plummeted globally leading to a significant decrease in private consumption. In the United States, private consumption fell -7.5% in March (calculated on a month to month basis). This is the sharpest decline in the history of the US economy.
A decrease in Fed Funds Rate would lead to the generation of affordable credit. With the reduced cost of borrowing, more people are likely to opt for debt. This increases liquidity in the economy and pushes demand. The newly acquired money encourages the general population to spend more, invest in financial assets and real estate, thereby increasing private consumption.

3. Inflation

Inflation refers to the general rise in prices of goods and services across the economy. It can also be viewed as a consistent decline in the purchasing power of money. Inflation is beneficial for the economy to some extent as it promotes citizens to invest their money in appreciating assets. It also stimulates production because businesses are more profitable when prices for goods and services gradually rise. Low inflation, on the other hand, slows down overall economic activity. In the US the inflation has rapidly declined due to the pandemic and the inflation rate (12 months ended April 2020) is a meager 0.3% (down from 2.3% in 2019). This is mainly because the population is limiting spending and hoarding cash.
Negative inflation or deflation is a possibility considering the economic repercussions of COVID-19. If demand continues to fall, the prices of goods and services would gradually decline and the purchasing power of money would increase. This would be detrimental for global economies as people would spend even less, preferring to retain cash, and businesses would experience reduced profitability.
A decrease in Fed Funds Rate would increase liquidity in the economy. This increased money supply would decrease the value of the currency, leading to higher inflation.

4. GDP and Exports

The GDP growth rate of the US plunged to -4.8% (calculated on an annual basis) in the first quarter of 2020. Their exports also fell significantly from 207 billion USD in February, to 187 billion USD in March 2020 (a 10% decline).
A cut in Federal Funds Rate would boost the money supply, leading to a subsequent decline in the value of the US Dollar.
A cheaper USD would make US Goods more affordable in the global market and expand exports. As the USD descends relative to other currencies, imports become more expensive. This discourages import activities, thereby, promoting the local industry.

It can be reasonably concluded that through these consistent rate cuts, the Federal Reserve plans to fix various economic barometers which were showing signs of sluggish or even negative growth. The effects of these cuts won’t be felt for 12-18 months. However, given the economic impact due to the pandemic, it is logical to speculate that the Federal Reserve rate cuts may continue. The pandemic has constantly startled global economies with unexpected challenges. The stock markets recorded all-time lows, oil futures went negative, and who knows if we might experience remarkably low or even negative interest rates in the future.