On September 18, 2024, the Federal Open Market Committee (FOMC) decided to lower the interest rate on the US dollar by 50 basis points (0.50%) for the first time since the COVID-19 pandemic, specifically since March 15, 2020. This decision came after a series of eleven rate hikes, interspersed with periods of stability, followed by a year-long hold. As a result, the interest rate on the dollar decreased from a range of 5.25% to 5.5% to a new range of 4.75% to 5%.
This move is widely seen as signaling the end of the monetary tightening cycle, as the Federal Reserve (the US central bank) finds itself caught between the pressure of the American labor market and its target of keeping inflation within 2%. The decision comes in the wake of a global wave of stock market declines that began on Wall Street, coupled with growing concerns over a potential economic recession in the United States.
The 0.50% interest rate cut represents a major turning point for the world's largest economy, particularly as geopolitical crises intensify in Ukraine and the Middle East. Historically, the Federal Reserve has made such moves in response to global shocks and crises, as evidenced by its actions in 2020 during the COVID-19 pandemic, in 2008 amid the global financial crisis, and in 2001 following the "dot-com bubble." With this decision, the Federal Reserve has brought an end to a four-year period during which borrowing costs were kept high in an effort to tame inflation.
Motivations for the Cut
While the decision to reduce the interest rate was anticipated, aligning with the Federal Reserve's soft landing strategy and market expectations of a 0.50% rate cut, it has not been without criticism. The Fed's chairman had signaled this move during the recent 2024 Economic Policy Symposium, yet several experts have taken issue with the timing. They argue that the Federal Reserve delayed the decision by a few months compared to its European and British counterparts.
The European Central Bank, for instance, had already lowered its rate by a quarter percentage point twice during 2024, while the Bank of England voted for a rate cut once in August. This lag prompted the Federal Reserve to opt for a more substantial 0.50% reduction instead of the typical 0.25%, effectively compensating for not reducing rates in July. This decision was driven by a combination of caution and risk management considerations.
The Federal Reserve bases its decisions on lowering interest rates on a set of economic indicators, including:
1- Inflation rate: Inflation in the United States has shown a marked improvement, dropping to 2.5% in August 2024 from a peak of 9.1% in June 2021. This decline is primarily attributed to decreases in energy and food prices. Projections suggest that inflation will continue its downward trajectory, eventually reaching the target rate of 2%.
2- Economic growth rate: The United States economy has maintained its expansion, with the GDP growing by 3% year-on-year in the second quarter of 2024, indicating steady economic activity.
3- Labor market: August 2024 saw the unemployment rate at 4.2%, a slight improvement from July's 4.3%, which had been the highest rate in three years. Currently, there are 7.1 million unemployed Americans, reflecting a recent slowdown in job creation.
Domestic Implications
After more than four years of monetary tightening, the US interest rate cut is expected to positively impact financial markets, the business community, and American households in the following ways:
1- Real estate sector: Mortgage loans are likely to be among the most noticeably affected by the reduction in interest rates for consumers. As mortgage rates are closely tied to government bond yields, which in turn reflect the Federal Reserve's monetary policy, they have already fallen to their lowest level in 19 months. Standing at 6.2% for 30-year fixed loans, these rates have dropped as brokers anticipated upcoming rate cuts. This downward trend is expected to continue as the Federal Reserve prepares for further rate reductions.
2- Consumer loans: With the Federal Reserve lowering interest rates, consumer loans, including auto loans, will become less expensive. Currently, interest rates on auto loans are at their highest level since 2001, having risen from below 5% in 2021 to around 8.7%. Similarly, interest rates on other types of consumer loans, such as variable-rate student loans and credit card interest rates, are anticipated to decrease.
3- Labor market: Businesses will also reap the benefits of easier access to loans, as lower interest rates typically correlate with increased employment opportunities. Reduced borrowing costs can improve companies' profitability, potentially leading to more hiring.
4- Stocks: The lowering of interest rates generally benefits stocks, as investors tend to pull their money out of low-yield government bonds and money market funds in search of more attractive returns in the stock market.
5- Savings: The most negative impact of lowering interest rates on Americans' financial situations is likely to be on high-yield savings accounts, certificates of deposit (CDs), and money market funds. These financial instruments, which have offered attractive returns to savers over the past two years, are closely tied to Federal Reserve interest rates. As a result, their yields will decrease rapidly as the Fed reduces interest rates, making them less appealing to investors.
6- Presidential elections: While Democrats have welcomed the significant interest rate cut and its role in stimulating the US economy, former President Donald Trump and his supporters argue that the decision was politically motivated. However, the substantial rate cut is likely to have only a marginal impact on the outcome of the upcoming US presidential election. It's important to note that neither candidate, Kamala Harris nor Trump, has control over monetary policy, although they may hope that the Federal Reserve's decisions—made independently from elected branches of government—will enhance their electoral prospects.
Global Implications
The US interest rate stands as one of the most critical economic indicators globally, exerting significant influence over numerous markets, including stocks, oil, gold, international, and cryptocurrency markets. Moreover, it serves as a primary reference point for central banks worldwide in determining their monetary policy directions. The Federal Reserve's decision to lower the interest rate will trigger several global consequences, with the most prominent effects including:
1- Rising gold prices: As the interest rate decreases, the opportunity cost of holding non-yielding assets like gold diminishes, while simultaneously weakening the US dollar. Consequently, gold prices have surged to record highs and are expected to continue their upward trajectory, potentially reaching $3,000 per ounce. This trend is further bolstered by the weaker dollar, lower bond yields, rising geopolitical tensions, and the likelihood of additional rate cuts by the Federal Reserve.
2- Decline in the US dollar index: The reduction in US interest rates has led to decreased demand for the US dollar against major international currencies. As a result, the dollar index has dropped from 106 points in May 2024 to approximately 100.6 points following the Federal Reserve's decision. Given the dollar's status as the world's primary reserve currency, the Fed's decisions are anticipated to significantly influence the future of foreign exchange markets.
3- Increase in cryptocurrency investment: Cryptocurrencies have experienced a substantial rise in response to the US interest rate cut. As the Federal Reserve continues to lower interest rates, digital currencies are likely to see further gains, fueling intensified speculation in the market.
4- Attracting more capital to emerging economies: The Federal Reserve's decision may help address economic challenges in emerging markets by attracting more capital and revitalizing bond flows. Investors are encouraged to seek more profitable investment opportunities in emerging markets with higher interest rates, such as Egypt and Turkey. This shift could potentially have a positive impact on foreign direct investment flows into these economies.
5- Alleviating external debt issues: For emerging and developing economies, lower interest rates help mitigate the burden of rising debt, particularly as much of their borrowing is typically denominated in US dollars. The reduction in US interest rates decreases borrowing costs for these markets, thereby easing their debt repayment pressures.
6- Rising oil prices: Oil prices have seen a weekly gain of 4%, supported by the US interest rate cut and a decline in US stockpiles, with Brent crude reaching $74.49 per barrel. Lower interest rates typically stimulate economic activity and increase demand for energy. The medium-term effects of the US rate cut on fuel prices are expected to be significant, provided that regional and international factors remain stable, Chinese demand stays strong, and geopolitical tensions do not escalate, which could otherwise cause unexpected fluctuations in oil prices.
7- Similar decisions by other central banks: Central banks in countries with economies closely linked to the United States often follow the Federal Reserve's lead by adjusting their interest rates correspondingly. In response to the recent US rate cut, Gulf countries have decided to lower their interest rates by approximately 0.5% to maintain foreign investments and reduce outflows from these markets.
Future Outlook
The Federal Reserve is poised to implement a series of interest rate reductions, with projections indicating a 50 basis point cut by the end of 2024, followed by a full percentage point decrease in 2025 and an additional half-point reduction in 2026. As the Fed's crucial meetings approach on November 7 and December 18, 2024, forecasts suggest a measured approach, with anticipated 25 basis point cuts at each of these gatherings. This strategy aligns with the Fed policymakers' goal of achieving a cumulative 100 basis point reduction by year-end 2024, reflecting their delicate balancing act between supporting economic growth and maintaining inflation control.
It is crucial to recognize that these projections are not set in stone and may evolve in response to various factors. Labor market conditions, inflation expectations, financial and international developments, as well as broader economic trends and global geopolitical events, all play a role in shaping the Fed's decisions. The impact of lowering interest rates on the US dollar typically unfolds over the medium to long term, necessitating vigilant monitoring of key economic indicators. This ongoing assessment allows for timely and positive responses to prevent potential negative outcomes in the foreseeable future.
In conclusion, the Federal Reserve's decision to implement a 50 basis point interest rate cut has sent ripples through global markets, with particularly notable effects on the gold market, emerging economies, and overall investor sentiment. As these monetary policy shifts take effect, continuous and meticulous monitoring of market indicators remains paramount. This vigilance is essential for striking the delicate balance between inflation control and growth stimulation in the short term.
