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The United States Federal Reserve (henceforth just ‘the Fed’), which is in charge of the country’s monetary policy, on Wednesday announced that it will cut the benchmark interest rate — the Federal Funds Rate — by 50 basis points, or half a percentage point.
A cut in interest rate typically incentivises economic activity, promotes growth, and increases job creation by making it cheaper for people to borrow money. Conversely, a hike in interest rates or persistently high interest rates tend to drag down economic growth and employment generation.
Changes to the US monetary policy — be it the amount of dollars being made available in the market or the price at which they can be borrowed (the interest rate) — has an impact that goes far beyond the country’s geographical borders. Among the most affected are emerging economies like India.
This is not just due to the US being the world’s biggest economy but also because the US dollar is the world’s most trusted and traded currency. Several countries hold US dollars as assets.
To counter the economic disruption and a recession experienced in the wake of the Covid-19 pandemic, the Fed had brought down interest rates close to zero (0.25% to be precise). However, as the US economy recovered, inflation started rising fast. Russia’s war with Ukraine and the associated supply disruptions made matters worse.
Initially the Fed was of the view that the inflationary spike was transitory but by March 2022, as inflation touched historic high levels, the Fed was forced to aggressively raise interest rates to cool down prices. Over the next 15 months, the Fed raised interest rates to 5.5%, and kept them at that high level until this decision.
By July, when the Fed last reviewed its policy stance, most expected a cut in interest rates because inflation had moderated considerably, and started moving towards Fed target rate of 2%. At the same time, as evidenced by jobs data, it was becoming clearer that the restrictive monetary policy was beginning to have a significant adverse impact on unemployment levels.
As such, it was widely believed that it is only a matter of time before the Fed shifts its focus from prioritising inflation-control to ensuring maximum employment. These two matters — stable prices and maximum employment — are part of the Fed’s “dual mandate”.
While announcing the cut on Wednesday, Fed Chair Jerome Powell accepted that if some of the recent reports on unemployment and inflation were known in July, the Fed would have started the cycle of cuts in July itself.
According to the latest Summary of Economic Projections (SEP), the Fed is likely to cut interest rates by another 50 basis points before the end of 2024, another 100 basis points in 2025, and another 50 basis points in 2026. With these cuts, the Fed hopes to achieve a “soft-landing” — reducing high inflation without crashing an economy into recession — for the US economy.
In 2022, most observers, as well as all past records, suggested that there is no way the Fed can contain inflation (which went as high as 9%) without resulting in a recession. However, as things stand, the Fed may have succeeded in threading that needle.
The US economy continues to grow robustly — SEP estimates GDP growth to be around 2% for the coming 2-3 years — and the unemployment rate, even though it has risen to 4.4%, is still fairly low and expected to trend downwards.
However, it must be remembered that the US will soon start to vote for a new President and all these projections about growth, inflation, and unemployment can change dramatically if a whole new set of policies come into the picture.
For instance, the Republican candidate and former president, Donald Trump has announced that he will impose wide-ranging tariffs on imports. But import tariffs are essentially a tax on domestic consumers — not the foreign country, as is often mistakenly assumed — and they end up raising domestic prices and fuel inflation.
There are many different ways in which India will be affected. India is a capital-scarce economy, and is always looking to incentivise foreigners to invest in India. Lower interest rates in the US will likely incentivise global investors to borrow in the US and invest in India — be it in stocks, debt, or in the form of foreign direct investment (FDI).
Repeated lowering of interest rates in the US will also lead to some weakening in the US dollar’s exchange rate with other currencies such as the Indian rupee. In other words, the rupee could see its exchange rate strengthen against the dollar. This, in turn, will impact India’s exporters (adversely) and importers (positively).
The RBI, India’s central bank, is already under growing pressure to cut interest rates. However, it is unlikely that the US decision will be critical in RBI’s calculations. This is because India and the US have significantly different inflation targets, vulnerabilities to inflation spikes, and policy mandates.
For instance, while RBI keeps an eye on GDP growth rate, it is not explicitly concerned with unemployment data. As has been seen in India over the past two decades, GDP growth can happen even without commensurate jobs growth.
