Second Look | A sign of a major policy shift by the Federal Reserve! “Rate cuts” are not a one-time deal

The shoe that the market has been waiting for has finally landed. The Federal Reserve announced a 50 basis point interest rate cut this morning Beijing time. The reason why this news has attracted great attention from the world is not only because it is the first interest rate cut in the United States in more than 4 years, but also because of the chain effect that the interest rate change of the world's largest economy may trigger on the world economy.

At the Federal Reserve monetary policy meeting held from the 17th to the 18th, the previous rumors of "announcement of interest rate cuts in September" by Federal Reserve Chairman Powell were confirmed. The Federal Reserve announced on the 18th local time that it would lower the target range of the federal funds rate by 50 basis points to a level between 4.75% and 5.00%. This is also the first interest rate cut by the Federal Reserve in four years. The Federal Reserve has raised interest rates 11 times in a row from March 2022 to July 2023, with a cumulative increase of 525 basis points. Over the past year, the Federal Reserve has maintained the target range of the federal funds rate between 5.25% and 5.5%, the highest level in 23 years. Ke Jing, an associate researcher at the Institute of International Studies of the Shanghai Academy of Social Sciences, said that the first interest rate cut by the Federal Reserve in four years marks a major policy shift in its response to economic changes. The main consideration for the interest rate cut is the balance between slowing inflation and a weakening labor market. Although the inflation rate is still slightly higher than the Fed's 2% target, it has fallen back to a controllable range, and the weakness of the labor market has exacerbated concerns about an economic slowdown. Therefore, the core purpose of the current interest rate cut is to truly achieve the Fed’s goal of a “soft landing” for the economy.

According to the Fed's forecast, the US federal funds rate will reach 4.4% at the end of this year, or the target range of 4.25% to 4.5%, and will fall to 3.4% by 2025 and is expected to fall to 2.9% by 2026. Ke Jing said that the Fed's interest rate cut this time is not a single action, but marks the beginning of a new round of interest rate cuts, and there should be more interest rate cuts in the future. The direct impact of a single interest rate cut on the economy and borrowers is limited, that is, although it will reduce borrowing costs, the impact on borrowers and the overall economy will not be immediately apparent. For example, although mortgage, car loan and credit card interest rates will decline with the interest rate cut, this impact will only have a limited effect on relieving pressure on borrowers and the market in the short term, and cannot completely solve the high financing cost problem faced by borrowers. As the interest rate cut cycle unfolds, its cumulative effect will gradually become apparent. For ordinary consumers, the continued decline in interest rates will significantly reduce the burden of home purchases, car purchases and credit card debts, and reduce monthly payments and interest expenses. For companies, the decline in financing costs will enable them to expand production, invest in new projects or expand, thereby enhancing overall economic vitality. By lowering interest rates, companies can access funds more freely, promote innovation and growth, and in turn promote employment and consumption, forming a positive economic cycle.

Compared with the previous rate hikes and no interest rates, what visible impact will the Fed's rate cut bring? Ke Jing said that the Fed's rate cut will also bring about a chain reaction around the world, especially those economies pegged to the US dollar.

First, capital flows to emerging markets may improve. When the Fed raises interest rates, investors usually withdraw funds from high-risk areas such as emerging markets back to the United States to obtain higher returns. When the Fed starts to cut interest rates, the situation may be reversed. The attractiveness of emerging markets will be enhanced by the decline in US interest rates, and funds may flow back into the stock and bond markets of these countries. For emerging market countries that rely on external capital support, this capital return will bring many benefits, such as stabilizing currency exchange rates, easing external debt pressure, and promoting domestic economic growth.

Second, the dollar may depreciate, thus affecting global trade. The Fed's interest rate cuts usually lead to a weaker dollar. Because when US interest rates fall, US dollar assets become less attractive to global investors, and funds may turn to other currency markets. This depreciation of the dollar is a big boon to US exporters, because a weaker dollar makes US goods more price competitive in the global market, thereby driving US export growth.

The impact of the depreciation of the US dollar on non-US exporters is complex. A lot of international trade, especially commodities and manufacturing, uses the US dollar as the main settlement currency. When the US dollar depreciates, the price of goods will be relatively cheap when exported to non-US markets settled in US dollars. In this case of using US dollars for settlement, the products of these export-dependent economies may be more attractive in the global market due to the depreciation of the US dollar. In addition, for countries that hold a large amount of US dollar debt, the depreciation of the US dollar also means that their debt repayment pressure is reduced because their debt burden is relatively reduced.

The third is the interest rate adjustment of countries pegged to the US dollar. Some economies pegged to the US dollar tend to follow the interest rate adjustment of the Federal Reserve. This means that the central banks of these countries may also reduce interest rates accordingly, which will affect borrowers around the world. The interest rate cut will reduce the borrowing costs of companies around the world, and the benefits of savings will decrease accordingly. Then the funds may flow into the stock market, pushing up stock prices and stimulating the prosperity of the global financial market.

Finally, the long-term impact and potential risks of the Fed's interest rate cuts. Although interest rate cuts can help stimulate economic growth in the short term, they are also accompanied by potential long-term risks. Excessive easing policies may lead to asset price bubble risks, especially in capital-intensive industries such as real estate and stocks. Continuous interest rate cuts will reduce borrowing costs and encourage speculative behavior, thereby pushing asset prices up too quickly. Once the asset bubble bursts, it may trigger severe market shocks and economic recession. This phenomenon has occurred in the real estate market before the 2008 financial crisis. Therefore, policymakers need to be highly vigilant about the real estate bubble and high leverage risks brought about by interest rate cuts.