Editor || Riya Grover
On 18th September 2024, Fed Chairman Jerome Powell announced a 50-basis point cut in the Fed Rate, lowering the range to 4.75-5.00%.
This move has been one of the most closely watched economic actions in recent times. The U.S. experienced its highest inflation in decades during 2022, which led the Fed to adopt a series of aggressive rate hikes to curb spending and control inflation. However, as inflation began to ease, there was growing pressure on the Fed to shift its approach. This adjustment also aims to keep unemployment at or below 4% while maintaining the Fed’s 2% inflation target.
“What does FED try to achieve by lowering the rates and the effects of lower interest rate in Economy”?
The Federal Reserve changed direction and started lowering interest rates to boost economic activity and aid in the recovery. The first idea was to apply a 25-bps reduction. But economic data and market dynamics necessitated a more substantial cut, which resulted in a 50-bps drop. As a result, the interest rates decreased to 4.75% from 5.25%. The desire to increase consumer spending, promote company investments, and avert a possible recession was the driving force for this significant decline. To boost growth and infuse cash into the economy, the reduced rates made borrowing more affordable.
The intended result of lower interest rates was to stimulate the economy. Consumer spending and company investment increased because of lower borrowing costs. Particularly in the property sector, there is expected to be a boom as mortgage rates fell and became more accessible for house loans. Although this boost in economic activity will create a chance that inflationary pressures may flare up again, so the Fed needs to closely watch the situation.
The Monetary Policy of the RBI: Is It Like the Fed’s?
RBI and Fed’s Policy Framework:
– Federal Reserve: The primary mandate of the Fed is dual—maximizing employment and maintaining stable inflation (around 2%). Its monetary policy focuses on interest rate manipulation (federal funds rate), open market operations, and quantitative easing.
– RBI: The RBI, like the Fed, also focuses on inflation targeting, aiming for around 4% inflation with a tolerance band of 2% on either side. However, RBI’s focus has historically been broader, balancing inflation control with growth support and exchange rate management, especially given India’s emerging market status and higher sensitivity to global capital flows.
How the RBI Has Followed the Fed in the Past:
1. Global Financial Crisis (2008):
During the 2008 financial crisis, both the Fed and RBI adopted expansionary monetary policies. The Fed slashed interest rates and introduced quantitative easing, flooding the U.S. economy with liquidity to prevent a deeper recession. The RBI also cut rates significantly and pumped liquidity into the financial system to cushion the domestic economy from the global shock.
– Fed Action: Reduced the federal funds rate from 5.25% in 2007 to near zero by late 2008.
– RBI Action: Reduced the repo rate from 9% in 2008 to 4.75% by April 2009.
2. Taper Tantrum (2013):
When the Fed signalled its intention to reduce bond purchases (quantitative easing) in 2013, emerging markets, including India, experienced massive capital outflows, currency depreciation, and inflationary pressures. In response, the RBI hiked interest rates to stabilize the rupee and prevent further outflows. This was a classic case of RBI responding to global cues set by the Fed:
– Fed Action: The Fed began signalling a reduction in asset purchases in May 2013.
– RBI Action: Raised interest rates in 2013 (repo rate hiked from 7.25% in May to 8% by January 2014) to stabilize the rupee.
3. COVID-19 Pandemic Response (2020): Both the RBI and Fed engaged in unprecedented monetary expansion during the pandemic to mitigate the economic collapse caused by lockdowns. The Fed reduced interest rates to near zero and engaged in large-scale asset purchases. Similarly, the RBI cut rates, provided liquidity to the banking system, and introduced targeted lending schemes to support businesses and consumers.
– Fed Action: Dropped federal funds rate to 0.00-0.25% in March 2020 and introduced new rounds of quantitative easing.
– RBI Action: Cut repo rate from 5.15% in early 2020 to 4% by May 2020, along with liquidity infusion measures.
4. Current Rate-Hiking Cycle (2022-Present):
Following the high inflationary pressure post-COVID-19, both the Fed and the RBI have been engaged in aggressive interest rate hikes. The Fed started raising interest rates in March 2022 to combat inflation, and the RBI followed suit shortly after, raising rates in May 2022. However, the RBI has been more cautious in its approach compared to the Fed, as India’s inflation dynamics differ due to factors like supply chain issues and food price inflation.
– Fed Action: Started hiking rates from 0.25% in March 2022, with multiple rate hikes, taking the rate to 5.25% by May 2023. – RBI Action: Raised repo rate from 4% in May 2022 to 6.50% by February 2023, largely in response to inflationary pressures driven by global oil prices and supply chain disruption.
India’s Repercussions: Foreign Investment and Currency Appreciation
India will be significantly impacted by the Fed’s decision to lower interest rate. First, there was an increase in the value of the Indian Rupee relative to the US Dollar. A weaker currency from lower US interest rates usually makes Indian exports more competitive while simultaneously driving down the cost of imports. India’s trade imbalance may be balanced with the aid of this dynamic.
Furthermore, foreign investments into India will increase because of the US’s reduced interest rates. When established markets provide lower rates, investors generally go to developing countries like India in search of greater returns. This inflow of foreign money has the potential to improve the nation’s overall investment environment, finance infrastructure projects, and spur economic development.
Effect on the Stock Market
The reduction in the Fed’s interest rates will have a significant impact on the stock market. Lower interest rates generally make equities more attractive compared to bonds, leading to increased investment in stocks. As borrowing costs decreased, companies found it cheaper to finance expansion projects, mergers, and acquisitions, which in turn bolstered investor confidence. This led to a rally in stock prices across various sectors, especially in interest-sensitive industries such as real estate, technology, and consumer discretionary. However, the stock market’s positive response also requires careful monitoring to prevent the formation of asset bubbles and ensure sustainable growth. This will lead to increase in investments in form of foreign direct investments and foreign institutional investments.
The Worldwide Setting
Considering the larger global situation is also crucial. The Fed doesn’t make decisions on interest rates on its own. Global central banks, such as the Bank of Japan (BoJ) and the European Central Bank (ECB), are also significant players in determining international monetary policy. Theirs and the Fed’s activities weave an intricate web of economic interdependencies that impacts all countries, including India.
Conclusion
The Fed’s interest rate reduction from 5.25% to 4.75%, reflecting a drop of 50 basis points, underscores the complex balance that central banks must maintain between fostering economic growth and controlling inflation. This decision not only impacts the domestic economy but also has ripple effects globally, as seen in the increased foreign investment and rupee appreciation in India. The Fed’s actions highlight the interconnectedness of global economies, where shifts in one major market can influence others, particularly in emerging economies. As the world navigates continued economic uncertainty, understanding the dynamic relationship between interest rates, inflation, and monetary policy will remain vital for investors and policymakers alike. This evolving landscape emphasizes the need for adaptive strategies to ensure economic stability and growth across borders.
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