The US Federal Reserve, in a historic move, cut its benchmark interest rate by 50 basis points (bps) for the first time since 2020. The federal funds rate now stands at 4.75%-5%, down from the 22-year high target range of 5.25%-5.5%. The rate cut followed a spate of 11 rate hikes since March 2022 (including four in 2023) to combat inflation.

The Federal Open Market Committee (FOMC) voted 11-to-1 in favour of the rate cut that occurred shortly before November’s presidential election. “We concluded that this was the right thing for the economy and the people we serve.” said the Federal Reserve Chair Jerome H. Powell.

The policymakers indicated more rate cuts are likely by the end of this year. As per the median of new economic projections published at the end of the policy meeting, interest rates could be lowered to a range of 4.25%-4.5% by 2024-end as inflation nears the 2% goal and unemployment spikes. This implies that an additional 50 bps cut might take place this year. Powell indicated they could speed up if the economy is weak and slow down if it’s strong.

The US market doesn’t seem to be spooked by the significant cut as modest movements were noticed in S&P 500 and tech-heavy Nasdaq. This is because investors have priced in the historic move with reassurance from the Fed that it wasn’t an emergency cut.

Inflation

The US Fed pulled off the daunting task of battling the pandemic-led inflation pretty well. In August, consumer price inflation reached its 3-year low at 2.5% (a tad higher than the pre-pandemic level), marking the 5th straight annual fall and the smallest hike since February 2021.

There are several triggers for the softer inflation. Gasoline prices in the US averaged $3.20/gallon, down $0.50 since April. Analysts believe the national average could further go below $3 in the near term. On the other hand, major retail chains like Walmart and Target announced price cuts on thousands of items to an extent that has put the business of discount stores in the US under pressure.

Along the cut comes big relief to credit card holders and home buyers in the US. Credit card debt has risen to the highest level since the 2008 financial crisis (so the credit card delinquencies) to US$1.14 trillion in the second quarter of 2024, according to data available from the Federal Reserve Bank of New York. Notably, it is the highest balance since the New York Fed began tracking the data in 1999 and up from US$1.12 trillion in the first quarter of 2024. Credit card rates averaged over 20% with store-branded cards witnessing a record-high average annual rate of 30.45%, as per data released by Bankrate.

The national average of mortgage rates stands at ~6.3% for a 30-year fixed loan. Mortgage rates, which are closely tied to 10-year Treasury bond yields that are coming down with inflation, will also ease with the benchmark rates going down.

Soft landing

Soft landing in an economy refers to a scenario when inflation is tamed without setting off a significant decline in economic activity. However, rising unemployment in the US remains a bigger concern and puts the soft landing in jeopardy. The unemployment rate has risen over the last one year and steeply since the beginning of 2024. Economists believe that whenever unemployment begins to rise, it tends to gain momentum and keep rising.

Impact on Indian market

Foreign investment: Foreign investment in India is likely to increase following the rate cut. When interest rates in the US rise, investors tend to flock to the US market to earn higher returns from Treasury bonds. A cut in the interest rate lowers the yields on US securities prompting investors to seek higher returns elsewhere with a healthy economic outlook. As a result, investment in Indian equity and debt markets could rise, pushing up the prices of securities.

Currency: As mentioned above, lower interest rates could lead to foreign investors chasing the Indian equity and debt markets. This would lead to higher demand for INR for investment purposes, potentially leading to an appreciation of the domestic currency. However, a stronger rupee has mixed impacts – it can lower the import cost and make business tough for Indian exporters on the other hand by making the Indian goods and services expensive for foreign buyers.

Bond Market: A cut in the US interest rates typically leads to a rally in the domestic bond market for reasons mentioned in the first point. In India, the bond market already priced in the rate cut with 10-year G-sec yields already dropping below 6.8%. Post the rate cut announcement, 10-year G-sec yields, in fact, opened above 6.8% on September 19 and became 6.867 at the time of writing after touching the day’s high of 6.893.

Conclusion

The US Federal Reserve joined other central banks across the world like the European Central Bank (ECB), Bank of Canada, and Bank of England in trimming benchmark interest rates. Other major central banks around the world are also expected to follow suit as the US Fed cut is one of the significant global monetary actions.

However, the Reserve Bank of India (RBI) is not compelled to follow suit as already indicated by the governor Shaktikanta Das. The inflation trajectory in India remains within RBI’s target of 4% (with a leeway of 2 percentage points on either side). India still remains the world’s fastest major economy. In the last policy meeting, RBI kept the GDP growth projection unchanged for FY25 (at 7.2%) as well as for Q2FY25, Q3FY25, and Q4FY25.

Further, RBI stressed that maintaining financial stability remains a top priority for the central bank. Hence, any decision to cut rates will be preceded by a full assessment of domestic economic conditions and potential risks.

Disclaimer:

The views provided in this blog are of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.