The United States Federal Reserve (from now on ‘the Fed’), which is in charge of the country’s monetary policy, on Wednesday announced that it will lower the interest rate – the Federal Funds Rate – by 50 points, or half a percent. the point.
Lower interest rates often stimulate economic activity, stimulate growth, and increase job creation by making it cheaper for people to borrow money. Conversely, interest rate increases or persistently high interest rates tend to reduce economic growth and job creation.
Changes in US monetary policy – be it the amount of dollars made available to the market or the amount at which it can be borrowed (the interest rate) – have an impact that goes far beyond the country’s geographical boundaries. Among the most affected are emerging economies such as India.
This is not only because America is the leading economy in the world but also because the US dollar is the most trusted and traded currency in the world. Several countries hold US dollars as a commodity.
Why is the Fed lowering interest rates?
To deal with the economic disruption and recession caused by the Covid-19 pandemic, the Fed lowered interest rates close to zero (0.25% to be exact). However, as the US economy recovered, inflation began to rise rapidly. The war between Russia and Ukraine and the accompanying supply disruptions made matters worse.
Initially the Fed was of the view that inflation was over but in March 2022, as inflation hit historic highs, the Fed was forced to raise interest rates aggressively to bring rates down. Over the next 15 months, the Fed raised interest rates to 5.5%, and kept them at that high level until this decision.
In July, when the Fed last updated its policy stance, most expected interest rate cuts because inflation had slowed significantly, and was beginning to move toward the Fed’s 2% target rate. At the same time, as evidenced by employment data, it was becoming clear that restrictive monetary policy was beginning to have a significant negative impact on unemployment rates.
Therefore, it was widely believed that it was only a matter of time before the Fed shifted its focus from prioritizing inflation control to ensuring high employment. These two issues – stable prices and high employment – are part of the Fed’s “dual mandate”.
While announcing the cuts on Wednesday, Fed Chairman Jerome Powell acknowledged that if some of the latest reports on unemployment and inflation were known in July, the Fed would have started a 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 “slow taper” – reducing high inflation without tipping the economy into recession – in the US economy.
Will the US economy reach a recession?
By 2022, most observers, along with all previous records, suggest that there is no way the Fed can contain inflation (which has risen to 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 strongly – the SEP estimates GDP growth at around 2% over the next 2-3 years – and the unemployment rate, although it has risen to 4.4%, is still very low and is expected to decline further.
However, it should be remembered that the US will soon start voting for a new President and all these predictions about growth, inflation, and unemployment can change dramatically if a new set of policies comes into the picture.
For example, Republican candidate and former president, Donald Trump has announced that he will impose a comprehensive tax on the sale of goods. But import taxes are taxes on domestic consumers – not foreign countries, as is often mistakenly thought – and they end up driving up domestic prices and fuel inflation.
How will India be affected?
There are many different ways that India will be affected. India is a deficit economy, and it is always looking to encourage foreigners to invest in India. Low interest rates in the US will likely encourage international investors to borrow from the US and invest in India – either in stocks, bonds, or in the form of foreign direct investment (FDI).
The repeated lowering of interest rates in the US will also lead to some depreciation of the exchange rate of the US dollar 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 Indian exporters (negatively) and importers (positively).
The RBI, India’s central bank, is already under increasing pressure to cut interest rates. However, it is unlikely that the US decision will be critical to the RBI’s calculations. This is because India and the US have very different inflation targets, inflation risks, and policy goals.
For example, while the RBI looks at the GDP growth rate, it is clearly not interested in unemployment data. As has been seen in India over the past two decades, GDP growth can occur even without commensurate employment growth.