In today’s Finshots, we explain what happens when the US central bank cuts interest rates and why it matters to you.

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The Story

Everyone’s talking about it — the US Federal Reserve (Fed) just cut rates for the first time in 4 years! And hey, not all of us are economics whizzes, so we thought we’d break it down. After all, why on earth should a US interest rate cut matter to you, right?

Well, we hate to break it to you, but it does.

Let’s set some context first.

See, the pandemic messed things up for everyone. No business or economy was spared. Not even the US. Supply chains were clogged, and when there’s less stuff in supply, prices naturally rise. So, that’s exactly what happened. Then, as people started leaving their homes, the demand for goods and services soared too. But with supply chains still in a mess, there wasn’t enough stuff to go around again. And that drove prices even higher.

But that’s only half the story. The other part is that the US government also stepped in during the pandemic by rolling out massive support programs, pumping about $5 trillion into the economy! With all this extra cash, people and businesses had more money to spend, which sent demand through the roof.

Add to that the fact that there weren’t enough workers to fill all the open jobs, and this made things worse. For context, between mid-2021 and early 2022, the number of US job openings doubled compared to unemployed workers! To attract employees, companies had to offer higher wages. And more money in the pocket meant more demand… you get the drill... It drove up the cost of goods and services all over again.

So it was no surprise that US inflation skyrocketed and hit a 40-year high of 9.1% in mid-2022. People started feeling the pinch, and the US Fed had to step in. The central bank said “Hey, let’s crank up interest rates to make borrowing more expensive. This way, people and businesses will spend less, and inflation will cool down.” And that’s how the Fed decided to bring inflation down to their now magic number ― 2%.

This 2% inflation target wasn’t an original US idea. It might have actually been borrowed from New Zealand. Back in 1988, New Zealand was battling decades of high inflation. Their Finance Minister, Roger Douglas, went on TV and set an ambitious goal ― to bring inflation down to a range between 0% to 2%. And that 2% inflation target soon became the global norm.

By 2012, the US adopted the 2% target, thinking that keeping inflation low and steady would help the economy in the long run. This also gave them room to adjust interest rates when inflation went off track.

And that’s exactly what the US Fed started doing. When inflation surged, it stepped in and raised interest rates 11 times in 2022 and 2023, to cool things down. The logic is simple. Raising interest rates makes borrowing more expensive, so people and companies tend to spend less. This helps bring down inflation.

But there’s a catch. Higher rates also mean borrowing costs go up for companies, leading to cost-cutting, slower expansion, layoffs and less hiring. So as a side effect of the rate hikes, US unemployment, which had been at its lowest since 1969, started creeping up.

So, last year, the Fed hit pause on raising rates even further and kept them steady instead. Until just a few days ago, when it finally decided to cut them!

Yup. From hiking interest rates, to hitting a pause, to cutting them.

And it’s all thanks to unemployment again. Because US unemployment had climbed up nearly 1% from its record low in April 2023, reaching 4.2%. Now, 4.2% isn’t too bad, but when unemployment starts creeping up like this, it often keeps rising. This can even spark a recession, because of something called the Sahm Rule. Named after former Fed economist Claudia Sahm, this rule says that if the three-month average unemployment rate rises by 0.5% from its lowest point in the past year, a recession is probably already underway. It’s actually been a reliable indicator for every US recession since 1970.

So, to prevent a bigger slowdown, the Fed cut rates by 0.5%.

Now, if you’ve been patiently reading this till here, you’re probably wondering “Why should I care if the US central bank cuts interest rates?”

Well, you see, the US plays a huge role in the global economy, and central banks everywhere keep a close eye on its moves to shape their own economic strategies.

There’s an old saying, “When the US sneezes, the world catches a cold.” So, the Fed’s actions, like interest rate cuts, can ripple through other economies.

For starters, lower US rates can make investing in countries like India more attractive. This strategy, known as carry trade, is where investors borrow money in the US (where rates are low) and invest it where rates are higher, making a profit on the difference. With more dollars circulating, the value of the dollar drops compared to other currencies. This could lead to more capital flowing into markets like India, potentially giving a lift to stock markets ― just like we saw yesterday, with most Indian indices trending upwards.

A cut in US interest rate also makes it cheaper for Indian companies to repay loans taken in US dollars. Because a lower interest rate reduces the cost of loan interest repayments. On top of that, a weaker dollar also means you need fewer rupees to settle the same amount of debt. Let’s say $1 is worth ₹85 today. If a rate cut weakens the dollar to ₹84, repaying a $100 million loan becomes cheaper — from ₹850 crores to ₹840 crores.

Then there’s the role of the US as the “lender of last resort”. This essentially means that the US steps in to lend money to countries in financial distress, preventing their economies from collapsing and causing global panic. Without this support, the economic troubles of one country could spill over to others and impact the US. So to manage this, it uses something called swap lines. These are financial arrangements between the US Fed and other central banks. Through swap lines, the Fed provides US dollars to foreign central banks, which then lend those dollars to their own financial institutions. This helps maintain global liquidity and trust in the dollar.

Without swap lines, foreign central banks might start selling their US Treasury bonds to raise money. These bonds are considered super safe because they’re backed by the US government. But if too many are sold at once, it could shake up the markets. So instead of letting that happen, the Fed steps in with temporary loans to these banks. And now, with lower interest rates, foreign banks can borrow dollars more cheaply, helping to keep global markets more stable.

But it’s not all sunshine and rainbows.

Take India’s IT sector, for example. Many Indian IT companies earn their revenue in US dollars. For context, in FY23, India’s tech industry raked in about $245 billion, mostly from service exports. So, lower rates and a weaker dollar could actually mean reduced revenues for these companies.

Then you have the effect on crude oil. When the US cuts interest rates, the dollar weakens, making commodities like crude oil more attractive to global buyers. This drives up oil prices, and for a country like India, which relies heavily on oil imports, it’s a big deal. The US is one of the largest crude oil suppliers to India. So, if oil prices spike due to lower US interest rates, like they’re doing now, India could end up paying a lot more for its energy needs. That could even push up inflation back home, making everything from fuel to groceries more expensive.

That’s a tough spot, especially with the US Fed hinting at more rate cuts in the coming months — up to six more times until 2025 – to bring them down to a sweet spot of 3% to 3.5% from the current 4.75% to 5% range.

And let’s not forget that lowering rates might help with unemployment in the US, but it can also push inflation higher all over again.

So yeah, in the end it’s a tricky balancing act that keeps central banks like the US Fed on their toes.

Until next time…

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