What the Fed Rate Cut Means for Inflation and the World Economy

Too many things to unpack here, right? US Fed cut, rate cut, inflation…!!

Let’s take a step back and start from the beginning: Monetary Policy.

What is monetary policy?

Monetary policy is the policy adopted by the central bank of the country (Federal Reserve in the USA’s case) to ensure maximum possible employment, stable prices & foreign exchange rates, and maintain a moderate level of interest rate in the long run, allowing for Gross Domestic Product (GDP) growth. 

Monetary policy can either be expansionary or contractionary depending on the decision taken by the Central Bank while they assess the health of the economy. An expansionary monetary policy aims to stimulate economic growth by encouraging borrowing, spending, and investment. A contractionary monetary policy aims to slow down economic growth.

Central banks can adopt an expansionary or contractionary policy in 2 ways. Either by influencing the money supply or by changing the interest rate payable on very short-term borrowings. For this article, I will only discuss the change in interest rate scenario to keep it relevant to the above news. However, you can read a detailed article about monetary policy here. 

What is the fed rate?

• The federal funds rate is the interest rate at which depository institutions, like banks and credit unions, lend reserve balances to other banks overnight on an uncollateralized basis. It is a key monetary policy tool used by the Federal Reserve (the central bank of the United States) to influence the overall level of economic activity, particularly interest rates throughout the economy.
• The Federal Open Market Committee (FOMC), a branch of the US Fed Reserve, is responsible for deciding the federal funds rate. The FOMC meets eight times a year to review economic conditions, such as employment, inflation, and economic growth. These meetings are when they discuss whether to raise, lower, or maintain the federal funds rate.
• Changes in the federal funds rate affect other interest rates throughout the economy, including:

• Interest rates on loans: Including mortgages, personal loans, and business loans.
• Credit card rates: Tied to the prime rate, which is influenced by the federal funds rate.
• Savings and deposit rates: Interest rates paid on savings accounts or fixed deposits.
• Treasury bond yields: The interest rates on government debt securities.
• Lower federal funds rates tend to make borrowing cheaper, encouraging more economic activity, while higher rates make borrowing more expensive, reducing inflationary pressures.

So what happened on Wednesday?

The U.S. central bank lowered interest rates for the first time in over four years, implementing a larger-than-usual cut. The Federal Reserve reduced its key lending rate target by 0.5% points, bringing it to a range of 4.75%-5%.

Starting in 2022, the Fed aggressively raised interest rates to cool the economy and stabilize prices, which had been rising at the fastest rate since the 1980s. These hikes, which resulted in higher costs for mortgages, car loans, and other debt, were designed to curb inflation by reducing consumer spending.

With inflation, the rate at which prices rise and ease, officials are now more focused on the risks high interest rates pose to the broader economy. The U.S. unemployment rate has increased to 4.2%, up from 3.7% at the start of the year, as hiring has slowed. Meanwhile, the annual inflation rate has declined for the fifth consecutive month, reaching 2.5% in August 2024—the lowest since February 2021—down from 2.9% in July and below the forecasted 2.6%. According to Trading Economics ‘global macro models and analysts’ expectations, inflation in the U.S. is projected to be 2.4% by the end of this quarter.

Why should you care?

A Fed rate cut has wide-reaching effects on both global financial markets and economies:

• A Fed rate cut often leads to a rally in stock markets around the world. This is because capital inflows into emerging markets, as investors seek higher returns than they can get in the U.S. In addition, lower interest rates reduce the cost of borrowing for companies, making it cheaper to finance operations and expansions. This boosts corporate profits, which can increase stock valuations and attract more investment in equities. 
• A Fed rate cut typically leads to a weaker U.S. dollar. This is often positive for emerging markets, as it reduces the burden of dollar-denominated debt and makes it easier for these countries to manage their external obligations.
• Lower interest rates in the U.S. can stimulate demand for imports from other countries, boosting global trade. Countries exporting to the U.S. may benefit from increased consumer and business spending in the U.S.

In essence, the Fed’s actions are closely watched by global financial institutions, as they influence capital flows, currency values, and economic conditions worldwide.

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