Fed can ease the supply of credit but not demand


Many investors hope that the Federal Reserve has their back. The US central bank has consistently said it wants to keep the economic expansion going, offering assurance to fund managers looking to the Fed to alleviate some of the discomfort expressed in markets by dramatically lower bond yields and a contorted yield curve.

But such faith in the Fed’s power to reverse August’s tumultuous events may be misplaced.

The primary tool the Fed has at its disposal, after all, is to cut interest rates. This is like turning on a tap to let the water flow through, only instead of water the Fed is opening up the spigots for credit. By lowering the cost of borrowing, the Fed is encouraging companies and households to lever up.

But it is doubtful whether encouraging more credit to flow will do the trick. Borrowing costs have been at or near historic lows for over a decade and most companies are hardly struggling to borrow what they want, judging by the rapid growth of US corporate debt markets.

Boosting spending is the real challenge. And here, the Fed has less control. Capital expenditure by US companies has slowed; expected to rise just 3.5 per cent this year, according to Citi, a sharp drop from a 4.2 per cent projection just a few months ago. The most common reason given is uncertainty over public policy, and more specifically over the ongoing trade war.

July’s durable goods data released this week seemed positive on the face of it, but digging into the underlying numbers revealed a different story. Stripping out a surge in aircraft and parts, core capital goods orders were down 0.3 per cent on a year-on-year basis — the weakest reading for several years.

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Those bleak numbers arrived shortly after another set of data showed the US factory sector in a rare period of contraction. IHS Markit’s US manufacturing purchasing managers’ index slipped to 49.9 this month, falling below its neutral level of 50 for the first time since September 2009.

Bill Dudley, former head of the New York Fed, put his finger on another potential problem this week, arguing that further stimulus from the central bank could have the effect of encouraging the Trump administration to open up new fronts in its trade battle with China. In that scenario, the private sector might be even less likely to spend and invest.

Still, investors are pricing in a near-certain chance of a rate cut by the Fed in September and there are cries for even looser financial conditions. Pimco’s US economist Tiffany Wilding said on Thursday that the Fed should slash rates more aggressively than the market currently anticipates.

The Fed might be the obvious candidate for coming to the aid of markets in distress but its desire to help is not the problem. Its ability is.

joe.rennison@ft.com



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