On the last day of July, the Federal Reserve generated headlines after announcing an interest rate cut. It’s the first such move since 2008 when the central bank really had no choice. During that awful period, the global financial system was on the brink of collapse.
But this time around, the economy – at least on print – has given the Fed every reason to raise rates. For instance, the labor market is robust, with unemployment down at multi-year lows. Seemingly, anyone that wants a job can find one. Further, the housing market in highly demanded regions have reached insane valuations.
Typically, the Fed would raise interest rates to cool sentiment. This allows overheated markets to reach a level of rationality, providing a more equitable ecosystem. However, an interest rate cut would do the opposite.
That’s because under this dovish context, it favors the borrower. More to the point, those who are heavily in debt receive the most benefit. They can pack back their liabilities with dollars that are worth less than the dollars used to get into debt.
Naturally, a rate cut hurts savers and lenders. The former has holdings that have declined in value. The latter will profit less from their lending activities.
But the latest rate cut goes beyond these relatively minor concerns. What it really shows is that the Fed’s efforts to stem the coming fiscal storm are futile.
Interest Rate Cut Merely a Temporary Fix
On a superficial level, I can see why the Fed did what they did. While our economy is chugging along, you can’t say the same about international economies. Because of globalization, a downturn in one region could create a ripple effect in other markets.
Plus, a lower interest rate environment can often spark commerce and investments. With borrowing costs down to a bare minimum, people will realize that there’s no better time to take a risk. Theoretically, then, the Fed can keep the real economy rolling.
But the problem is that the big banks aren’t profiting from a robust business environment. Instead, they’re making money off net-interest income. That’s the difference between revenue generated from a bank’s assets and outlays for liabilities (such as customer interest).
Put another way, post-2008 crisis, the banking system has generated money from merely existing. As holders of the world’s reserve currency, the Fed has advantages that all other nations lack. But such tactics work only with other nations’ cooperation.
Here’s the thing: other nations also want to make money. And they’re not going to do so holding low-interest bearing dollars. Thus, we may save ourselves some pain for now. But an even bigger crisis is waiting in the wings.