Question

It's a weak economy. The Fed implements stimulative monetary policy to lower rates, expecting firms will increase borrowings. Banks are willing to lend. Why might the Fed's expectation that firms will borrow be wrong? What happens if they're wrong?

What are the markets expectations for future rates?

Answer 1

During a weak economy, it is intuitive that the health of firms is not good. As such, even with the Fed pushing for a stimulative monetary policy, it may not be feasible for firms to borrow because the cash flows generated from the project are not sufficient to to pay off the interest amounts and generate profit. Given that the economy is weak and the sentiment of the people and businesses is declining, even in the abundance of capital raising instruments, firms may shy away from borrowing.

If the rates are reduced yet the firms do not borrow, this step of quantitative easing will not help in fostering economic growth and as such the revival of the economy will be stalled and stagnated. The Fed had to almost give loans at 0% interest after the 2008 crisis because even at very low rates, firms were not willing to borrow.

Since the Fed had shown signs of a stimulative monetary policy, the general perception of the market is that rates will further reduce and quantitative easing as a process will continue for longer. Thus, a few firms wait for the interest rates to decline further and this can again spiral into the Fed being caught in its own web thus leading to a further weakening of the economy.