Commentary
When it comes to the US presidential election and former President Trump’s trade policies, it’s easy to think that these are the main factors driving the market. However, the real mover of the market appears to be changes in interest rates. Central banks around the world are either cutting rates or planning to do so soon. The initial reaction is that this will benefit both the market and the economy. But a series of interest rate cuts, whether done as a precaution or in response to economic pressures, may actually indicate underlying issues. Conventional wisdom suggests that when the Federal Reserve starts a cycle of rate cuts, it’s time to sell. This has held true for the past three decades.
There is a complex relationship between the economy and interest rates. Cutting rates can stimulate the economy through various channels. Essentially, interest rates represent the relative price between the present and the future. By cutting rates, the cost of borrowing now becomes cheaper compared to borrowing in the future, which can encourage more economic activity in the present. However, the effects of such rate cuts can take time to fully manifest in the economy, typically around one to two years.
On the other hand, countercyclical policy dictates that central banks should lower rates when there are signs of an economic slowdown. But economic downturns do not always unfold in a linear fashion; they can be more abrupt. While indicators like rising unemployment and falling inflation point to a weakening economy, the severity of the downturn is still uncertain.
Examining the causality between interest rates and the economy can shed light on which side influences the other more. Historical data shows that there has been a mostly positive correlation between economic growth and interest rate changes. This suggests that changes in real GDP growth may drive interest rate changes, rather than the other way around.
Although the Fed typically raises rates during economic expansions and lowers them during contractions, there have been periods of low correlation, indicating a more balanced causality. Currently, there is a noticeable negative correlation between interest rates and the overall economy, implying that higher and prolonged interest rates could lead to lower economic growth in the long run. However, the impact of interest rate changes on the economy tends to be short-lived.
As the economic downturn becomes more evident, the Fed will likely respond with rate cuts. This could result in a cycle of rate cuts rather than a one-time adjustment. The market may not have fully priced in this impending economic downturn, but as it unfolds, it may be seen as a “black swan” event that was previously unforeseen.
Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
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