Fed rate cut: With the US Federal Reserve expected to announce a rate cut this week, the world waits with bated breath as the decision will have global implications. This would mark the first rate cut in four years, coinciding with a looming US presidential election. Fed policymakers are currently debating the size of the cut ahead of the announcement, expected on September 18 (US local time). With inflation easing towards the central bank’s target of 2%, and the labour market cooling, senior Fed officials, including Chair Jerome Powell, have signalled that a rate cut is imminent.
The key question facing policymakers is whether to opt for a 25 basis points (bps) or 50 bps cut. A modest 25 bps cut would allow for a gradual adjustment, while a more aggressive 50 bps cut could provide a stronger boost to the labour market, though it may risk reigniting inflation. Current economic conditions suggest that monetary policy should remain neutral, neither constraining nor stimulating economic activity excessively.
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No Fed rate cut since March 2020
The last rate cut by the Fed was in March 2020, when rates were slashed to near-zero to support the US economy during the COVID-19 pandemic. Since then, the Fed, along with other central banks, raised interest rates throughout 2022 and 2023 to combat inflation driven by supply chain disruptions and the war in Ukraine. The goal was to cool economic activity and reduce demand to bring prices down. However, maintaining high interest rates for an extended period risks pushing the economy into recession.
The US Congress mandates that the Federal Reserve prioritise price stability and sustainable employment. The Fed has emphasised that its rate decisions are based solely on economic data, free from external pressures. Over the past 14 months, the key lending rate has been at a two-decade high, between 5.25% and 5.50%, as the Fed waited for improved economic conditions.
Now that inflation has returned to target levels, the Fed is preparing to gradually reduce interest rates, aiming to avoid recession and achieve a soft economic landing.
The Fed’s interest rate decisions significantly affect global markets. Lower US rates can weaken the dollar, making US exports more competitive but also increasing the cost of imported goods. Investors may seek higher returns in other markets, potentially leading to capital outflows from the US and putting pressure on emerging market currencies and economies.
Lower rates can also boost economic growth and corporate earnings, pushing stock prices higher, though the impact varies across sectors and regions. Bond prices tend to rise when rates fall, benefiting existing bondholders but potentially reducing returns for new investors. Additionally, lower rates may drive up demand for commodities, raising prices for assets like oil and metals.
Impact on India
A US rate cut may prompt India’s central bank to consider cutting rates as well. However, the Reserve Bank of India (RBI) has been cautious about lowering rates. The RBI’s Monetary Policy Committee (MPC) will review this in upcoming meetings, especially as more clarity emerges on food inflation trends.
Foreign investors may look to emerging markets like India for higher returns, leading to increased foreign capital inflows into Indian equities and debt markets. Indeed, net foreign portfolio inflows into Indian equity markets have resumed and are expected to grow. Increased foreign investment typically boosts demand for the Indian rupee as investors convert their currencies to INR, potentially leading to an appreciation of the rupee against the US dollar.
However, India may not benefit as much as other emerging markets, as Indian valuations are already relatively high. Experts suggest that the coming months will clarify whether markets will favourvalue or growth during the rate-cutting cycle. While India offers attractive investment opportunities, other undervalued markets may also draw attention due to their lower valuations. Although India’s banking sector holds potential value, other sectors may be overvalued.
The magnitude of the Fed’s rate cuts will have significant consequences for emerging markets. As the International Monetary Fund noted in its July World Economic Outlook, many central banks in these economies remain cautious about lowering their rates, mindful of external risks like changes in interest rate differentials and potential currency depreciation against the dollar.