A sharp reduction in interest rates by the Federal Reserve (Fed) of the USA can have a wide range of consequences for the economy and financial markets. To understand what this might lead to, it's important to consider the context and reasons for such a move.
Possible consequences of a sharp rate cut:
1. Strengthening incentives for the economy:
• Rate cuts make loans more accessible for businesses and households. This can stimulate growth in investment and consumption.
• May temporarily support financial markets, as lower rates increase the attractiveness of stocks and other assets.
2. Dollar devaluation:
• Low rates reduce the yield of dollar-denominated assets, which may lead to a weakening of the US currency in global markets.
3. Inflation growth (in the long term):
• If the rate cuts lead to excessive stimulation of the economy, it could trigger inflation growth, which would require subsequent tightening of policy.
4. Deterioration of financial stability:
• Excessively low rates may spur speculation in the markets (creating 'bubbles' in real estate, stocks, or other assets).
• If the rate cuts are driven by crisis-related factors (e.g., a recession threat), this could intensify panic sentiments.
What was happening in 2007?
In 2007, the Fed's rate cuts began in response to signs of economic slowdown and the collapse of the mortgage-backed securities market. Key events of that time:
• Bubble in the real estate market: Extremely low rates in the early 2000s stimulated the growth of mortgage lending, including high-risk loans (subprime).
• Financial crisis: When real estate prices began to fall, many borrowers could not service their debts. This caused the collapse of the mortgage-backed securities market and a liquidity crisis.
• The 2008 recession: The economy entered a deep recession, with major banks on the brink of bankruptcy, requiring massive intervention from the Fed and the government.
Could this happen again?
• Similar signs today: If the Fed sharply cuts rates again in 2024, it may indicate deep problems in the economy, such as a looming recession, liquidity crisis, or financial instability.
• Differences from 2007:
• Today, regulators have a better understanding of the risks in the financial system and pay more attention to stress-testing banks.
• However, corporate and government debts are now higher than in 2007, which may increase vulnerability in times of crisis.
If a sharp rate cut is accompanied by financial shocks (e.g., a banking crisis), it could trigger a chain reaction similar to the 2008 crisis. However, if the Fed's actions are coordinated and well thought out, the consequences may be less dramatic.
