How much will the Fed cut? That is the question. Here’s why

Decision time for banks around the world

On Wednesday, the Fed is expected to somewhat belatedly join other central banks around the world in kicking off its own rate-cutting cycle after a gap of more than four years. The anticipation has been building up since Fed Chair Jerome Powell’s speech at an economic symposium in Jackson Hole, Wyoming, late last month that came closer than any of his remarks earlier to a declaration of victory over the inflationary surge that set in after the Covid-19 pandemic.

In his address, Powell finally said out loud what Wall Street has been predicting for some time now — that a cut is clearly in the offing. The European Central Bank last week pruned its policy rate by 25 basis points to 3.50%, following a similar cut in June. Brazil’s central bank, too, is slated to hold its policy meeting on Tuesday, while the Bank of England, Norway’s Norges Bank, and South Africa’s Reserve Bank are all slated to wrap up their meetings on Thursday.

The Bank of Japan, which had surprised some market participants in July when it decided to raise borrowing costs, is set to announce its latest rate decision at the end of its two-day meeting on Friday, bringing to an end a busy week for central banks around the world.

Expectations vary on quantum of Fed cut

The size of the Fed’s first rate cut since March 2020 represents a “weighty decision,” New York-based sell-side consultancy Yardeni Research founder Ed Yardeni said in a Monday note to clients that was quoted by Forbes.

Market expectation of the odds of a 50 basis-point cut rose from 50% on Friday to 57% on Monday, even as the probability of a 25 basis-point cut slid from 50% to 43%, according to futures contract data tracked by Chicago-based CME Group’s FedWatch Tool, a widely cited proxy for investor expectations. The CME group owns 27% of S&P Dow Jones Indices.

While the market seems to be increasingly rooting for a higher quantum of cuts in the run-up to the meeting, economists are split on what they expect the Fed to do.

JPMorgan’s top US economist has been quoted as having told clients that the bank expects the Fed to cut rates by 50 basis points, while Goldman Sachs’ chief US economist has weighed in favour of a 25 basis-point cut, saying that “larger cuts have historically come in the context of an obvious crisis or at least a layoff spiral”, which is not the case currently.

Signals in Powell’s Jackson Hole speech

While the speech given by Powell at the symposium last month made it all but certain that the American central bank would cut rates, the lack of any guidance at that time was perhaps indicative of the Fed chief wanting to keep his options open.

The other factor in the Fed’s dual mandate alongside keeping prices stable — the objective of ensuring maximum employment — was also being tracked closely. Powell indicated at the symposium that his worries were now tilting towards that side. The Fed has kept its key lending rate at a two-decade high of 5.3% since July last year, holding off on cuts that other central banks such as the ECB had already commenced months ago.

It needs to be noted that the US has seen a recession — or a significant cooling of economic activity — after almost every time the Fed has hiked interest rates in a sustained manner to control inflation. This time could be different: a soft landing — sustained high levels of inflation being brought down without setting off a recession — looks highly possible.

In his Jackson Hole speech, Powell took note of the sharp slowdown in the American job market, and said that the Fed did not “seek or welcome further cooling”. He also shrugged off concerns about another recession in the near future, arguing that the rise in unemployment was consistent with a slowdown in hiring, not a sudden spike in job cuts.

“There is good reason to think that the economy will get back to 2% inflation while maintaining a strong labour market,” he said.

Impact of Fed rate cut on India and elsewhere

Like other central banks such as the Reserve Bank of India (RBI), the US Fed influences employment and inflation primarily by using monetary policy tools to control the availability and cost of credit in the economy. The Fed’s primary tool of monetary policy is the federal funds rate, changes in which influence other interest rates — which in turn influence borrowing costs for households and businesses, as well as broader financial conditions.

When interest rates go down in an economy, it becomes cheaper to borrow; so households are more inclined to buy more goods and services, and businesses have an incentive to borrow funds to expand operations, buy equipment, or to invest in new projects.

Improved demand for goods and services ends up pushing up wages, and helps rekindle the growth cycle. Even though the linkages of monetary policy to inflation and employment are not direct or immediate, monetary policy is a key factor in curbing runaway prices or stoking the growth impetus.

A cut in interest rates in the US could have a three-pronged impact.

When the Fed cuts its policy rates, the difference between the interest rates of the US and the other country could widen — thus making countries such as India more attractive for the currency carry trade. The lower the rate in the US, the higher the arbitrage opportunity, till the time that the rate-cut cycle starts in other economies as well.

A lower rate signal by the Fed would also mean a higher impetus to growth in the US, which could be positive news for global growth, especially when China is reeling under the impact of a real estate crisis and showing signs of slowing down.

Lower returns in the US debt markets could also trigger a churn in emerging market equities, improving foreign investor enthusiasm. There is also a potential impact on currency markets, stemming from inflows of funds.

For the RBI, like other central banks, the likelihood of a future rate cut is somewhat predicated on the US Fed’s decision to cut rates. The RBI last cut the repo rate by 40 basis points to 4% in May 2020, when the Covid-19 pandemic affected the entire economy, leading to slowdown in demand, production cuts, and job losses.

Since then, the RBI has hiked the repo rate by 250 points to 6.5% in order to tackle runaway inflation. The Indian central bank has a mandate to keep inflation at 4%, with a cushion of 2% on either side.

The next meeting of the RBI’s Monetary Policy Committee (MPC) is scheduled for October 7-9.