Federal Reserve chairmen are partly blaming trade wars for the Fed interest rate cut, according to The Washington Post. Federal Reserve Board Chair Jerome H. Powell announced the cut on July 31, citing weak global growth and trade tensions. Other economic forces also play a role in federal interest rates.
The article in The Washington Post said that “18 months of on-again, off-again tariffs—and tariff threats—against products from China, India, Mexico, Canada, the European Union, South Korea, Japan, Vietnam, and Guatemala” have crippled business confidence and U.S. investment rates. This particular rate cut could hurt the perception of the Federal Reserve’s independence in the eyes of other countries, as Powell and others have reported feeling forced into the decision by the slowing global economy, resulting partially from President Trump’s trade wars. Federal interest rates have historically been affected by many factors, from deficits to recessions.
The Long Run: Ideal Economics
To understand the consequences of a federal interest rate adjustment, it helps to think of it in terms of the long run and the short run. Before that, though, we should look at the cause-and-effect origins of interest rate changes. “First, a change in interest rate directly affects many economic markets, while a change, say, in the price of corn directly affects only a few,” said Dr. Michael K. Salemi, Professor of Economics at the University of North Carolina at Chapel Hill. “Second, it is through interest rate changes that central banks attempt to stabilize the economy, keeping inflation low and steady and keeping output near full-employment levels.”
In the long term, these points are vital. Dr. Salemi noted that over extended periods of time, the economy stays near full employment and the government’s budgets are balanced. “That means, approximately, that the value of goods and services that we import from the rest of the world in a year is just equal to the value of goods and services that we export to the rest of the world in that same year,” he said. “There has to be a kind of balance between outflow to the rest of the world and inflow from the rest of the world.” Unfortunately, this is a bit idealistic and rarely do so many economies exist in such a state of perpetual harmony.
The Short Run: Economics in Today’s World
In the “short run,” or real-world economics, interest rates vary for many reasons. When a government spends more than it earns—in other words, when it runs a deficit—it must borrow money, competing with private investors. “If the government deficit increases, other factors unchanged, the demand for funds increases and the interest rates rise,” Dr. Salemi said. Because of this, “some investment projects no longer are sufficiently profitable [enough] to justify doing, in the face of the higher interest rates.”
On the other hand, nations also run what are called “current account deficits,” which report the difference between the values of its imports and exports. “When the U.S. runs a current account deficit, the rest of the world, in effect, lends it purchasing power,” Dr. Salemi said. “That is, the trading partners of the United States are in a situation where they prefer to take some of the dollars that they receive by selling goods to the United States and use those dollars to buy financial assets, say those issued by the U.S. Treasury and also those issued by firms; in effect, our trading partners lend us funds.” When they do so, the United States is able to make more investments, which helps keep interest rates low.
A final factor leading to changes in federal interest rates is when an economy is in a recession. “When the economy is in a recession, demand for credit is low, in part, because firms doubt that households will buy their credits,” Dr. Salemi said. “Therefore, interest rates are low because demand for credit is low. In a recession, interest rates may also be low if the Federal Reserve uses monetary policy to lower them in an attempt to stimulate interest-sensitive spending.”
So-called “long-run” economies are the kind of goal we always race towards but never quite reach. However, they’re useful as a comparison when we look at “short-run” economies on the national scale. Imposing tariffs or bans on goods imported from other countries is one way to affect international commerce and, eventually, federal interest rates, which is what happened last week. However, other factors like competition over funds, current account deficits, and recessions also influence federal interest rates in various ways.
Dr. Michael K. Salemi contributed to this article. Dr. Salemi is Professor of Economics at The University of North Carolina at Chapel Hill. He completed undergraduate studies in economics at St. Mary’s College in Winona, Minnesota, master’s degrees in economics from Purdue University and the University of Minnesota-Minneapolis, and a doctorate in economics from the University of Minnesota-Minneapolis.