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Analyzing the Economic Impact of Federal Reserve Rate Cuts

LONDON (Reuters) – As speculation mounts regarding potential interest rate reductions by the Federal Reserve, it’s crucial to consider not just the anticipated boost to borrowing but also the potential drawbacks regarding income levels in the U.S. economy.

The unfolding narrative surrounding the Fed’s easing cycle reveals a rather complex dynamic: while interest rate hikes previously bolstered cash income from the banking sector, a reduction in rates could reverse this trend. This counterintuitive situation may lead to complications for the U.S. economy if it does not respond favorably to lower borrowing costs.

Recent analysis by strategists at Morgan Stanley highlights the significance of income generated from the central bank’s rate hikes. Historically, such hikes had a tendency to dampen negative impacts on the economy caused by elevated borrowing rates. However, with rates potentially declining, the reverse effect could dampen overall economic benefits derived from any future cuts.

Today’s Federal Reserve operates differently than its predecessors, particularly in terms of how it interacts with commercial banks. It now pays considerable interest for the reserves held in these banks, a practice established following the financial crises of 2008 and the COVID-19 pandemic in 2020. Even though excess reserves have diminished over the past year, they have stabilized at approximately $3.1 trillion.

In addition to interest payments on reserves, the Fed’s daily reverse repo facility also offers interest to manage excess liquidity. Even though this volume is currently only a fraction of its peak, it amounts to a significant $300 billion to $400 billion nightly.

Investment in short-term interest-bearing assets, especially in money market funds, further highlights the implications of the Fed’s rate decisions. A substantial portion of the $6 trillion in these funds is invested in U.S. Treasury bills, which have enjoyed elevated interest rates in alignment with the federal funds rate in recent years. However, as the trend reverses, the income generated from these investments is likely to follow suit.

The Fed’s aggressive rate hikes from 2022 to 2023, which resulted in a 5 percentage point increase in the fed funds rate, significantly enhanced interest income across various levels of the economy. Thus, any substantial cutting of rates could diminish cash income and market liquidity even as credit becomes cheaper.

According to Morgan Stanley’s assessment, if the Fed were to revert to a “neutral” rate near 3% in the next couple of years, the resultant income loss could proportionately impact the economy similar to the effects seen when rates neared zero in 2020. This potential drag could ripple through various sectors, influencing bank profitability, lending practices, corporate cash reserves, and even household wealth.

Despite these challenges, such a drag might be a necessary component for a central bank attempting to recalibrate its policies toward a healthier economic balance, especially in light of the economy’s resilience. A careful moderation of stimulus could effectively counteract any undesirable over-stimulation that the easing measures might inadvertently create.

Nevertheless, should the U.S. economy experience unforeseen shocks or a resurgence of deflationary pressures, the Fed might find its rate cuts less effective than anticipated, possibly pushing it to lower rates more dramatically than currently projected. This scenario raises the once-remote possibility of re-entering an environment characterized by near-zero interest rates, reminiscent of the conditions preceding the pandemic. Similar concerns about low inflation are already surfacing in regions like Switzerland, the eurozone, and China.

This evolving situation could also disrupt the Fed’s quantitative tightening strategies. With U.S. commercial bank reserves nearing what many believe to be a steady state, many analysts predict that the central bank may halt its balance sheet reduction efforts next year.

If the income drag becomes a significant concern, discussions regarding the end of quantitative tightening could gain urgency. The complexities of the Fed’s monetary policy reflect the intricate balance it must maintain while navigating the current economic landscape.

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