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Does the Fed have room to breathe if the US economy goes south?

Despite the Fed’s current tightening cycle making gradual progress in recent years, US interest rates remain very low – is the country at risk of giving itself little room to breathe in the event of another market crash?

After cutting interest rates close to zero during the financial crisis in 2008, the US central bank raised base rates for the first time in nearly a decade in December 2015 to 0.5pc.Since then, it has raised rates a further five times, culminating in an increase to 1.75pc in March this year before holding them at this level in May. The market expects another interest rate rise in June but cannot agree on whether the central bank will hike three or four times this year.

With unemployment hitting its lowest level in 18 years, Trump signing in massive tax cuts and federal spending increases, and inflation at nearly 2.5pc, some worry the US economy is now at risk of over-heating. Couple this with concerns of a trade war arising from Trump’s plans to introduce harsh tariffs, ongoing sanctions against Russia and frosty relations with Iran, and the US growth story starts to look less secure.

Looking at the chart below, sourced from Bank of America Merrill Lynch and Bloomberg, it is clear that Fed tightening cycles almost always end with a burst triggered by an economic event. As it stands, the base rate still sits below the target 2-5pc range that typically indicates a healthy economy and is very low relative to historical standards. If things turn bad for the US, and the tightening cycle stops at this very early stage, then it begs the question of what the Fed will do with such limited scope to drop rates.

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