Interest Rate Cuts: What Does It Mean for the Global Economy?

Today, markets are awaiting the US Federal Reserve’s decision on interest rates, as it heads for its first cut since the start of the Covid-19 pandemic – and while the move is widely expected, global investors are bracing for the impact.

Advanced Decisions:

The Fed is behind a group of its central bank peers, including those in the eurozone, the UK, Canada, Mexico, Switzerland and Sweden, which have all already cut rates.

Many of these policymakers have stressed their willingness to go further than the Fed – often seen as a global leader – in response to slowing growth and easing inflationary pressures at home. However, some analysts have questioned how far they will go before the Fed – the world’s largest central bank by assets – follows suit, given the impact its actions are creating.

Global Impact:

A key concern is the pressure on interest rate differentials on currencies. In general, higher interest rates attract more foreign investors looking for better returns, which in turn boosts the value of the local currency.

This has been seen in the current cycle, according to CNBC, with the Japanese yen and Turkish lira taking a hit as their central banks kept interest rates low, while the US dollar – as measured against a basket of currencies – has strengthened throughout 2022 as the Federal Reserve delivered aggressive rate hikes. These spreads are particularly difficult for central banks trying to keep rising prices in check, as a weaker currency can be inflationary as it increases the cost of imported goods.

Aside from foreign exchange, another important impact of the Fed’s rate setting is its impact on the US economy, especially given the recent focus on the weak labor market and the possibility of a recession.

Asset Prices:

“As an important driver of global growth, it is bound to have an impact on asset prices around the world,” said Richard Carter, head of fixed interest rate research at Quilter Cheviot.

That includes gold – which hit a record high this week amid expectations of a move by the Federal Reserve.

Rising interest rates are generally seen as a drag on gold because they make fixed-income investments, such as bonds, more attractive, although that hasn’t always been the case historically.

Gold is also used as a hedge against inflation (which can be pushed higher as prices fall) and investors also buy the precious metal in times of market stress.

Oil and other commodity prices, which are typically priced in dollars, often get a boost from interest rate cuts as lower borrowing costs can stimulate the economy and boost demand. Many emerging markets are affected by these factors, making Fed moves more important to them than larger economies.

Stock markets are also affected by Fed moves – and not just in the US. Much of the global stock market volatility in recent months has been tied to speculation about when and by how much the US central bank will cut interest rates.

Richard Carter of Quilter Cheviot continued in the same vein: “Rate cuts reduce the cost of borrowing in US dollars, thereby creating easier liquidity conditions for companies around the world.” He noted that: “Lower US rates should also reduce the yield available on US assets such as Treasuries, thereby making other markets relatively more attractive.” Target levels:

While markets are confident that the Fed will begin its easing cycle on Wednesday, there is considerable uncertainty about the extent and speed of its move during the three remaining meetings this year and into 2025. This includes whether the initial cut will take the federal funds rate by 25 basis points or 50 basis points below its current range of 525 to 550.