Trump slows down benchmark interest rate: What does it mean for Ukraine?

Author : Oleksiy Kushch

Source : 112 Ukraine

The US recent attempt to move to higher base rates almost caused the collapse of developing countries' economies
20:16, 27 June 2019

Open source

The US recent attempt to move to higher base rates almost caused the collapse of developing countries' economies, which faced a huge outflow of liquidity. The ensuing weakening of the monetary strangulation in the form of a pause in the increase in interest rates somewhat stabilized the situation. Indirectly, we also felt this in the form of stabilization of the national currency.

If the expectations of leading US analysts are met and the base rates do go down, this would lead to a significant liquidity inflow of investors in developing countries. Zero and even negative return of the leading developed countries of Europe (+ Japan) have already led to the global retirement investment and venture funds simply have no opportunity to earn a minimum return for their clients.

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The only alternative to emerging markets is the United States, where the yield on Treasury debt instruments is more than 2%, and in general, investing in a package of reliable stock instruments would bring 5% +. In this context, each reduction in the US Federal Reserve's base rate means hundreds of billions of dollars in new liquidity, which would spill onto the markets of developing countries badly affected by financial drought.

In June 2019, the regular meeting of the US Federal Reserve was held, and the corresponding press release was announced. The Board of Governors of the Federal Reserve System decided to maintain the interest rate on mandatory and excess reserves of banks at the level of 2.35%.

This rate was reduced from 2.4 to 2.35% in May of this year. As for the federal funds rate, it is kept in the range of 2.25-2.5% and will continue to serve as a guide for the special management of the Federal Reserve in terms of its operations in the open market. The above range of returns is targeted for the United States, that is, it contributes to maintaining the target for inflation of 2% against the background of steady economic growth.

For this, the Federal Reserve System uses a standard set of monetary instruments, for example, sale/repurchase of treasury bonds in System Open Market Account with a yield of operation (offer) of 2.25% and a limit per counterparty of 30 billion dollars per day.

The rate of reduction of the Federal Reserve System’s balance sheet remained at the same level, which was lowered in winter: $ 15 billion in Treasury bonds and $ 20 billion in mortgage loans per month. The so-called "primary loan" rate remained at 3%.

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According to the analysts, the new wave of the Federal Reserve System’s rate hike can be activated no earlier than 2020, and this fall, we might even have a slight downward correction (by -0.25%).

The monetary authorities are forced to sacrifice long-term disinflation policy plans and move on to the tacit support of the new industrialization program in the format of the return of Detroit’s former glory. Fortunately, there are short-term favorable factors in the form of relatively low current inflation, which makes it possible to stop monetary maneuvering in the short term.

Can we say that the period of tight monetary policy is already in the past? James Bullard, chief executive officer and 12th president of the Federal Reserve Bank of St. Louis, is sure of this and convinces the financial world that in these months a reserve has been formed for several years. At least the base rates would not rise or they might be even reduced. It seems that the United States is not afraid of inflation, but of the deflationary trap. The EU would soon face the deflationary trap too.

In America, the deflationary trap has always caused a surrealistic horror, since long-term price cuts do not fit in with the economic model of the “American dream” and the general business drive of the local business environment. These fears make analysts lay three cuts in the Federal Reserve System’s basic rate for 2020.

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The problem of deflation in the US should be solved by Trump's new industrial policy, because the main factor behind the price reduction is growing imports from other countries, mainly developing ones, whose currencies are constantly depreciating against the dollar, and consequently, the prices of their products are constantly falling.

Here let us return to Ukraine. The policy of the National Bank of Ukraine (NBU) contributes to the formation of positive inflation expectations when the population and business expect a slowdown in price growth. At the same time, our devaluation expectations are quite strong. Everything is logical here: inflation is the only target of the NBU, so the body actively promotes and partially fulfills it (the target inflation rate has significantly decreased in recent years and now stands at 5% for 2020).

At the same time, the regulator completely refused to forecast the exchange rate corridor of the national currency, declaring a transition to a floating, free exchange rate. But even according to estimates of the National Bank, the dollarization of the banking system (foreign currency deposits and other instruments) is now 40%, while the optimal level is 20%. The population and business do not perceive the policy of the NBU, aimed at the complete refusal of any responsibility for the currency rate.

Consequently, the following planning horizon is formed in Ukraine: inflation will decline, and hryvnia will devalue. Given the level of dollarization, this is a hidden quasi-deflationary trap.

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Yes, a partial surge in the real estate market is still observed, but most of the capital continues to be stored in the safes, banking cells and offshore accounts. Something similar is happening (with a large correction factor for scale and specificity) in Japan, where private companies store about $ 2 trillion in their accounts, expecting the further cheapening of basic assets within the country.

One of the key economic riddles of modern times is when and how the super-long business growth cycle in the USA, which has been observed for ten years, ends. The former Federal Reserve System management thought that there was nothing terrible about recycling and it was better to cleanse inflation "toxicosis" with the help of high-interest rates than to destroy the economic organism for another couple of years.

An aggressive policy of Donald Trump, who stated that the Federal Reserve System does not understand anything, was the opposite - lowering interest rates and stimulating the economy. But it also meant "welcome back, our new financial bubble."

For Ukraine, this is another historic chance to start a new recycle of economic development on a completely different growth model. Investors will look for some risky but profitable investments of their capital, and we can offer them for potential points of growth of our economy.

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