The US Federal Reserve has shifted policy with a chunky half-percentage point cut in its policy rate on Wednesday, joining others like the European Central Bank and Bank of England in lowering the cost of borrowing. This is the US Fed’s first post-pandemic reduction and marks the start of a monetary easing cycle.
Also, it pivots the American central bank’s focus away from inflation-control to ensuring a soft landing for the world’s biggest economy. Having faced criticism for being late in acting against the cost-of-living on its way up, and then effecting steep rate hikes (over 2022-23), the Fed seems wary of erring on the jobs front as US prices have cooled, which may explain the jumbo sized cut.
Rate changes take time to work their way through the economy. So, the Fed, finally confident that its 2% inflation target is within reach, may have judged it prudent to go for a big cut now before other economic indicators could turn gloomy. “The US economy is in a good place and our decision today is designed to keep it there,” Fed chair Jerome Powell said.
America’s unemployment rate has risen by almost a percentage point since early 2023 to about 4.2% now. While this is not painfully high, it’s at risk of worsening. By encouraging consumers to spend more and businesses to invest, cheaper credit should act as a cushion against the turbulence of a possible slowdown.
With the Fed funds rate now in a lower range of 4.75% to 5%, data on the US economy as we go forward will determine the pace and timing of the Fed’s future moves. Its rate-setting panel’s ‘dot-plot’ points to cuts of another 150 basis points by 2025-end.
What the economy’s ‘neutral’ rate is, the one at which output growth gets neither spurred nor squeezed, remains under debate. If it is assessed to have gone up, as the US bond market fears, then this easing cycle may plateau higher than before, leaving the US with real rates above pre-covid levels. Still, America escaping a recession would be good for all its trade partners.
As for capital flows, a rise in global risk-on sentiment, typical of rate cuts, could boost capital flows to emerging markets (EMs), strengthening their currencies and assets. US equities had a muted response to this week’s Fed action, but over time, the Indian stock market could gain.
Even though high valuations may make some overseas investors demur, its recent edging out of China’s market as the world’s largest EM on a key index reflects its growing heft and appeal overall. Indian bonds may also draw more inflows if their yield gap with US paper gets more attractive (US bond yields rose at first, though).
Our businesses may seek more foreign loans, too. While inflow volumes may stay moderate at most, they could yet prove large enough for the Reserve Bank of India (RBI) to step up its rupee vigil.
A strengthening currency is bad for our exports, but can be moderated by RBI with dollar purchases, the excess local liquidity caused by which need not be mopped up with open-market bond sales (‘sterilized’) if it happens to coincide with a policy pivot of its own.
Some forecasters expect Indian inflation to soften, letting RBI shift stance and effect a repo rate cut, but this would only be towards the end of 2024. While retail prices may turn benign by then, as some trends suggest they would, India’s central bank must retain price-stability as its priority till this goal is securely met. This means it will need to either let the rupee rise or sterilize its forex-market buys.