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The Federal Reserve made headlines this week by slashing interest rates by half a percentage point, marking its first rate cut in over four years.
This reduction lowers the federal funds rate to a range of 4.75% to 5%. This shift is a significant change in the Fed’s strategy, as it moves from combating high inflation to stimulating economic growth.
The backdrop: From pandemic to inflation battle
The Federal Reserve’s role is to juggle two crucial tasks: keeping inflation under control and maintaining low unemployment. Since the pandemic, this balancing act has been particularly challenging.
When the pandemic hit, the economy took a nosedive. To counteract this, the government unleashed massive stimulus packages, which helped businesses and individuals but also created a surge in demand. This surge, coupled with supply chain disruptions, sent inflation soaring to 9.1% by June 2022.
To tame this runaway inflation, the Fed took drastic measures, raising interest rates 11 times between March 2022 and July 2023. Higher rates were meant to cool off the overheated economy by making borrowing more expensive, which in turn should slow down spending and reduce inflation.
Fast forward to now, and the inflation rate has dropped to 2.5%. While this is a significant improvement, it’s still above the Fed’s target of 2%. Unemployment, which had reached historically low levels during the peak of the recovery, has now risen to 4%.
When the Fed raises interest rates, the cost of capital for companies goes up. This means borrowing money becomes more expensive. In response, companies may cut back on hiring or even lay off employees to manage their increased expenses.
This rise in unemployment is partly a result of the Fed’s higher rates, which have slowed down economic activity and job growth.
With inflation under control but unemployment on the rise, the Fed is at a pivotal juncture. Unemployment is ticking up, and central bankers don’t want the economy to slow down too much. Hence, the rate cut.
A shift in strategy: Enter the rate-cutting era
This week’s cut brings the federal funds rate to around 4.9%, down from more than a two-decade high. The Fed, led by Chair Jerome Powell, is hoping to thread the needle between taming inflation and preventing the job market from softening any further. The rate cut is a clear sign that the Fed is shifting its strategy — from hiking rates to slowing down the economy, to now trying to keep it afloat.
Powell made it clear that more rate cuts are likely on the horizon. But the Fed isn’t following a strict script. If the economy shows more signs of weakness, expect more cuts. If things pick up, they may slow down the pace of reductions.
The Fed’s game plan: Soft landing in sight?
The big question: Can the Fed manage a “soft landing” — where inflation drops without causing a full-blown recession? Powell and the Fed believe they’re on track to pull it off. There’s growing confidence within the central bank that they can continue lowering rates without hurting the overall economy.
But it’s not all smooth sailing. The Fed is keeping a close watch on the uptick in unemployment, though Powell reassured that the economy is fundamentally strong.
The impact on markets
Financial markets reacted swiftly to the Fed’s announcement. Stocks initially surged on the news of the rate cut, with the S&P 500 briefly hitting a record high. However, the gains were short-lived, and by the end of the day, markets had closed in the red. Investors appeared to be grappling with the implications of the Fed’s move, particularly concerns that the central bank might be trying to get ahead of a more significant economic slowdown.
Bond markets also reacted to the news. Yields on Treasury bonds, which move inversely to prices, dipped slightly. The yield on the two-year Treasury note, which is particularly sensitive to Fed policy, fell by 0.06 percentage points to 3.59%.
How interest rates will affect US consumers?
- Borrowing Costs Will Fall:
- Mortgages: If you’re looking to buy a home or refinance, you’re likely to see lower mortgage rates. The average 30-year fixed mortgage rate has already dropped to around 6.2% from nearly 8% last October. Although this is a step in the right direction, it might not return to the low rates seen in 2021 anytime soon.
- Other Loans: Rates on auto loans, personal loans, and credit cards should also decrease. However, because these rates are more closely tied to the Fed’s policy changes, they might take a bit longer to adjust.
- Savings and Investments:
- Savings Accounts and CDs: As the Fed cuts rates, high-yield savings accounts and CDs are likely to offer lower returns. If you’ve been relying on these for higher interest, expect your earnings to drop.
- Stock Market: Lower interest rates generally make stocks more attractive compared to safe assets like government bonds. This could push stock prices higher over the long term, though short-term reactions can vary based on economic outlooks.
- Housing Affordability:
- Home Prices: Despite lower borrowing costs, housing affordability remains challenging. High home prices and a tight supply of houses continue to strain the market. However, lower mortgage rates might eventually help by encouraging more housing supply and potentially making homes more affordable.
- Impact on Jobs and Inflation:
- Job Market: The Fed’s rate cuts aim to support job growth by making borrowing cheaper for businesses, which could help sustain hiring. Even though hiring has slowed, the unemployment rate remains relatively low.
- Inflation: With inflation under control and rates lowered, you might find that your paycheck stretches a bit further, though daily expenses may still be high compared to a few years ago.
- Future Outlook:
- Further Cuts: Financial markets anticipate more rate cuts, potentially bringing the Fed’s policy rate to around 4.00%-4.25% by year-end. While the Fed is cautious about returning to ultra-low rates seen before 2022, gradual cuts could further ease financial pressures.
How a Fed Rate Cut Impacts Indian Markets
When the U.S. Federal Reserve cuts interest rates, it’s not just a domestic affair. The effects ripple across global markets, including India. Here’s how these rate cuts could affect you and the Indian markets.
When the Fed reduces interest rates it makes borrowing cheaper in U.S. dollars. This easing of liquidity conditions is intended to stimulate economic activity by encouraging borrowing and investment. The excess liquidity results in a shift in investment flows. Lower U.S. rates can lead to reduced yields on U.S. Treasury securities, prompting investors to seek higher returns elsewhere, including in emerging markets like India. This influx of foreign capital can benefit Indian equities and debt markets, particularly sectors with high growth potential.
New-age companies in India, which are often seen as growth stocks, might see increased investor interest.
Impact on the Indian Rupee and Foreign Investment
A Fed rate cut typically increases the attractiveness of emerging markets by making them more appealing relative to U.S. assets. As foreign investors convert their currencies into Indian Rupees (INR) for investment, demand for the rupee rises, potentially leading to its appreciation.
Historical Performance During Fed Cycles
Historically, Indian markets have shown mixed reactions to Fed rate cuts. The general pattern has been that Indian equities tend to fall following such moves. This is partly because a Fed rate cut is sometimes perceived as a sign of economic weakness, prompting a global risk-off sentiment. Investors often retreat from riskier assets, which include Indian equities.
The impact, however, is not always straightforward. Looking at historical data, the Nifty index has shown notable movements during Fed easing and tightening cycles. For instance, during the Fed’s easing cycle from July 1990 to February 1994, the Nifty surged by 310%. Similarly, during the tightening cycle from June 2004 to September 2007, the Nifty experienced a 202% gain.
Conversely, there have been tightening phases where the Nifty saw declines. For example, there was a 23% drop from February 1994 to July 1995 and a 14% fall from March 1997 to September 1998. On average, the day after Fed announcements, the Nifty’s return has been a modest -0.2%.
In summary, while Fed rate cuts often trigger initial market jitters, their long-term impact can be positive, especially for growth-oriented sectors and emerging markets like India. The key will be monitoring how these changes align with global economic conditions and investor sentiment.
What lies ahead?
The Fed’s decision to cut rates by half a percentage point marks the beginning of a new chapter in U.S. monetary policy. After more than a year of holding rates at their highest levels in over two decades, central bankers are now shifting their focus toward stabilizing the labor market. While inflation remains a concern, the Fed is confident that it is on the path back to its 2% target.
However, challenges remain. The U.S. economy is still navigating uncertain waters, and the Fed will need to carefully balance its efforts to support the labor market without letting inflation creep back up. With more rate cuts likely in the months to come, the Fed’s actions will continue to play a critical role in shaping the economic landscape.
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