US central bank faces a two-way dilemma

The US Federal Reserve will advise on further interest rate policy this week. It was still almost a foregone conclusion until recently that interest rates would continue to rise in the US. However, the trade conflict and the resultant growing concerns about growth have raised expectations that the Fed will lower the fed funds rate by up to three times in the course of the year. Some investors are not ruling out an interest rate cut even this week.

The US central bank is now up against a dilemma once again. It is not in its interest to nip every key rate cut fantasy in the bud. This could lead to high levels of volatility on financial markets and conjure up far-reaching recessionary concerns. However, the Fed will not want to fuel market participants’ expectations of a quick and sharp reduction in key interest rates either. Consequently, it needs to achieve a balance of opening the door for a potentially more expansionary monetary policy without sounding overly concerned. The press release following the FOMC meeting will be appropriately balanced. Expectations of interest rate cuts will however be strengthened in general, which could support the financial markets in the short term. Nonetheless, this is not expected to be a long-term development.

The problem the Fed actually faces is fewer options, even though it has more opportunities available to it for countering an economic downturn than other central banks. In addition, its independence is increasingly taking centre stage in the discussion. US President Trump has been calling for lower interest rates for quite some time already. While the Fed has rejected this so far, it is now softening its tone. It is impossible to say whether this is due to political pressure or really only because of the rise in economic risks. However, it can be said that an interest rate cut in the months ahead would be the first in a scenario of such low unemployment and inflation.

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