Cutting Interest Rates Won't Help | Forex Fundamental Analysis

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Cutting Interest Rates Won't Help

The ECB (European Central Bank) and the BoE (Bank of England) both cut their primary benchmark rates today. The cut was not unexpected although I suspect most traders and analysts were expecting a slightly smaller chunk. The BoE is now at a record low of 2% and the ECB is trailing with an all time record of 2.5%.

The trend so far for the major economies seems to be towards a primary rate of 0% (the Japanese are essentially already there) but will it be effective? That is an excellent question and I think it depends on an entirely different measure.

Cuts in the primary rates are having a hard time translating into lower rates for consumers and business because the primary rate is so far below inflation. For example, right now the Fed funds target rate in the US is 1% but inflation (CPI) is at 4%. A bank isn't going to lend at lower than 4% because they will lose money to inflation. Add to that number enough interest to compensate for risk and you get the commercial rates we currently see in the US.

The inflation problem means that cuts to the primary interest rate while it is this far below inflation levels will not translate very well to the rest of the economy. This is a major component of a liquidity trap. To see a series of articles on this specific problem of liquidity traps, deflation and credit crises, click here.

The number most traders should be watching is CPI on December 16th. If inflation continues to ease then we may see more loosening in the credit market. However, if we see CPI creep up then things could get much worse. These are short term indicators but can be important ones from a forecasting perspective.

For traders this means that stable or higher CPI will likely support the trend in the USD while a shift lower is going to be disruptive and risk coverage will be important. The rate cuts in the world's major economies will have less impact until we know that number.