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The United States Federal Reserve (‘the Fed’) announced that it will cut the benchmark interest rate the Federal Funds Rate by 50 basis points, or half a percentage point.
The Federal Reserve is the central bank of the United States that performs several functions to promote the health of the economy and financial system.
The Federal Reserve was established by Congress in 1913 in response to the banking panic of 1907. The Federal Reserve is considered independent because its decisions don't need to be ratified by the president or other government officials, but it is subject to congressional oversight.
The Federal Reserve sets monetary policy to promote stable prices, maximum employment, and moderate interest rates. It uses three tools to influence the federal funds rate, which in turn affects other interest rates, foreign exchange rates, and economic variables.
The Federal Reserve monitors the financial system for systemic risks and regulates financial institutions to ensure their safety and soundness.
Due to the disruption by the Covid-19 pandemic, The Federal Reserve cut interest rates to near zero (0.25%) in response to the economic disruption.
However, as the economy recovered inflation rose, geopolitical tensions increased and this prompted a shift in policy.
Consequently, from March 2022 onward, the Fed raised rates aggressively and it reached 5.5% in August 2024 to combat inflation.
By mid-2023, there were growing expectations for rate cuts as inflation moderated, and many believed the Fed would prioritise maximising employment.
This shift aligns with the Fed’s dual mandate, which aims to balance stable prices to ensure maximum employment. This fed rate cut is the result of inflation meeting this objective.
Lower interest rates generally stimulate economic activity by making borrowing cheaper, which in turn promotes growth and job creation.
Conversely, higher interest rates tend to slow down economic growth and reduce employment opportunities.
Higher interest rates in the US would make American assets less appealing to investors, this would potentially lead to capital inflows in emerging and riskier markets.
Monetary Policy Changes in U.S. monetary policy have significant effects on economies worldwide, particularly emerging markets like India will be impacted. This influence is largely due to the U.S. dollar’s status as the most trusted and widely traded currency and many countries hold it as a key asset.
The US Federal Reserve’s aggressive cuts might pave the way for the Reserve Bank of India to lower interest rates. With India’s consumer price inflation (CPI) already easing below the RBI’s 4% target, two potential rate cuts of 25 bps each by March 2025 seem likely.
Lower interest rates in the U.S. may encourage global investors to borrow and invest in India, through stocks, debt, foreign direct investment (FDI), etc. as the burrowing rate in the US would be cheaper.
Foreign investors will be tempted to withdraw from the US market and invest in Indian assets, as the Dollar and the US Treasury yield will become less attractive in the US and the Indian market begins to see capital inflow.
Thus, an interest rate cut in the US decreases the relative returns on dollar investments, which will weaken the US currency.
Weakened U.S. dollars would strengthen the Indian rupee, which would have mixed impacts on Indian exporters and importers as the cost of import would decrease and the cost of export would increase.
Important articles for reference
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PRACTICE QUESTION Q.The United States Federal Reserve recently announced the first ever benchmark interest rate cut after the 2019-Covid pandemic. In this context, discuss how the fed rates are intertwined with policy rates in other economies around the world. (150 words) |
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