Resolved Question
What is a rate cut? How does it affect the forex market?
As I understood from my readings, a rate cut is like flooring your gas pedal when driving but the car doesn't accelerate until ten minutes later. There is always lag between the actions of a central bank and its effect in the economy so if an economy is growing there will always be some kind of inflationary pressure. Most inflation level is leveled at the 2-percent mark. Can someone please explain this statement further to me?
5 months ago
Best Answer - Chosen by Voters
A rate cut is one of the major tools that a central bank uses in order to induce business activity. However, it is bearish for the country's respective currency because it makes investments in that country less attractive compared to that of the other countries. Remember that you need to change your money to the local currency in order to invest in them. Hence, a lesser demand for the country's investment instruments would translate to a lesser demand for the domestic currency as well. The opposite happens for a rate hike.
Now, the market's immediate reaction, though, is different if they already expect a cut or a hike. Usually, a decision that is in line with expectations leads a "sell on news." Surprise cuts or hikes are the ones that cause an immediate impact on the respective currencies short term valuation.
5 months ago
Answers (1)
Nice analogy! Although central banks implement rate cuts in order to spur economic activity (such as borrowing, spending, and investment), the effects take a while to catch on. This is why most central banks made more than a couple of successive rate cuts during the economic crisis. Of course they wanted to accelerate the activity in the economy so much that they slashed borrowing costs to record lows in order to pump up liquidity and stimulate the flow of cash.
After a series of rate cuts, however, the rate of return on a nation's investment also drops. This makes their assets relatively unattractive to investors so they'd rather put their money elsewhere, particularly in countries which offer higher rates of return. This gives rise to carry trade, where investors buy up the currency of the country with higher interest rates and sell the currency of the country with lower exchange rates. As a result, countries with higher interest rates (such as Australia) experience an appreciation of their local currency.
Your next statement states that the growth of an economy gives rise to an increase in price levels. This is why, when the country has convincingly moved out of the recessionary phase, central banks need to hike rates back up. Recall that slashing rates results to increased liquidity and, if the economy is already back on track, this could result to inflation. Raising borrowing costs would then mop up the excess liquidity in the market and bring inflation down, possibly to keep it within the central bank's target range (for instance, 2%).
5 months ago
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