06 August 2019 15:19:17 IST

A management and technology professional with 17 years of experience at Big-4 business consulting firms, and seven years of experience in high-technology manufacturing, Rajkamal Rao is a results-driven strategy expert. A US citizen with OCI (Overseas Citizen of India) privileges that allow him to live and work in India, he divides his time between the two countries. Rao heads Rao Advisors, a firm that counsels students aspiring to study in the United States on ways to maximise their return on investment. He lives with his wife and son in Texas. Rao has been a columnist for from the year the website was launched, in 2015, and writes regularly for BusinessLine as well. Twitter: @rajkamalrao

Why central banks are easing money supply

The rate cuts aim to energise global economies hit by inflation, production gluts and low spending

First, it was the Reserve Bank of India. In June, for the third time in a matter of months, the powerful central bank had cut the repo rate — the rate at which it lends money to member commercial banks for overnight loans. Economists now believe that a fourth rate cut is imminent.

Next was the US’ Federal Reserve Bank. After consistently raising rates in 0.25 per cent chunks from 2016 through now, and with the rate at 2.25 per cent, the Fed lowered its funds rate by 0.25 per cent this week. This was the first rate cut since the Great Recession, when the funds rate hit zero, and stayed there for many years.

And now there’s talk that the European Central Bank, where the rate is already at -0.4 per cent (meaning commercial banks are paying the ECB for the privilege of guarding their deposits rather than receiving interest for them), is considering lowering the rate still further in September.

What is going on?

The main culprit is inflation, which seems to be steady worldwide. Central banks carefully watch money supply because too much money in the economy makes people want to outbid each other to buy products and services, while too little money chokes economic growth. In India, where inflation rates of 6 per cent were common just 15 years ago — and inflation hit 12 per cent in 2013 — the RBI has set a “just-right” inflation target rate of 4 per cent. Yet, for the last year or so, India’s inflation is coming in nearly a percentage point below this target. In other words, prices are steady or, worse, falling.

Perhaps it is the worldwide glut in production from China’s factories which are borrowing heavily from the Chinese government and continuing to make things, ignoring the downturn caused by the trade war with the United States. Perhaps it is that automation has continued to inject even more efficiency so that companies can produce more with less. Or, in a worst-case scenario, people are struggling with their incomes, and are unable to afford what they want to buy, causing a gradual slowdown in the world economy — and forcing companies to sell for less to attract buyers. Perhaps it is a combination of all these factors.

Consider oil markets. Iran, a major producer, has had its supplies virtually stopped by US sanctions. Ordinarily, this would have spooked the markets and driven prices sky-high. Worse, Iran is in open conflict with the West. It claimed that it had shot an American drone and recently captured a British oil tanker. The war in Yemen continues. Yet the price of oil closed around just $55 a barrel, about a third of what it was at the peak of the second Gulf war.

Fed rate cut and oil prices

In fact, when the Fed announced its rate cut this week — effectively lowering the value of the dollar and making all commodities, which are priced in dollars, dearer — the price of oil actually fell further. This is similar to employees getting raises and finding out that their favourite restaurants have simultaneously lowered prices. Normally, one would expect restaurants to raise prices knowing that employees have more money in their pockets.

Central banks, therefore, are beginning to inflate the economy, signalling that prices are too low. By lowering interest rates — or in the case of the ECB, by printing money and quantitatively easing the money supply — central banks are placing more cash in the hands of consumers’ pockets, in the hopes that they would get into a pricing war and bid prices up.

A year ago, I described how the Trump economy has many safeguards — both via monetary and fiscal policies — to keep it humming. The US economy continues to outperform every indicator. Stock indices are at record levels. Unemployment rates, at 3.7 per cent, are at historic lows. The trade war has shaved some shine off of US GDP, and the production of the Boeing 737 Max being suspended has had a negative impact.

Quantitative easing

When the new GDP numbers came in at a healthy 2.2 per cent last week — but not the high rates of the last two-and-a-half years — the Fed immediately stepped in to lower rates to nudge the US back to the high economic growth numbers it has been used to. In the meantime, Congress passed a massive budget, with a $1-trillion in deficit spending for each of the next two years. This fiscal policy measure will again prime the pump and keep economic activity high.

Some economists believe that there is an excess of $12 trillion in quantitatively-eased cash around the globe when central banks gleefully printed money from thin air over the last two decades. The world has gotten used to this free money and doesn’t want to give it up any time soon. The world’s central banks are happily ready to oblige our indulgences.