Fed's balancing act: Why this rate-easing cycle will be different

Since the US economy is not in distress, lower interest rates may increase spending relatively quickly. Also, Mr Powell termed the cut a calibrated attempt to take the policy rate to the neutral rate

The US Federal Reserve (Fed) did not want to be wrong again. After misreading the inflation surge following the pandemic, it wants to ensure a soft landing for the US economy. The unemployment rate increased to 4.2 per cent in August, as against 3.8 per cent a year ago. Consequently, the Federal Open Market Committee (FOMC) of the Fed on Wednesday decided to reduce the target range for the federal funds rate by 50 basis points to 4.75-5 per cent. The US central bank raised policy interest rates 11 times starting early 2022 to the highest level in decades to contain the inflation rate, which peaked at 9.1 per cent in June 2022. Although the markets expected a rate reduction of 25-50 basis points, stocks in the US ended the day’s trade in the red after the S&P 500 hit record highs. The stock markets in India remained flat on Thursday.

While the Fed started the easing cycle with a 50-basis point-rate cut, its future action and the scope of rate reduction remain debatable. Fed Chairman Jerome Powell was categorical in his post-policy media interaction that the markets should not interpret this as the new pace. Projections by Fed officials suggest another 50-basis-point policy rate reduction this year, followed by a 1 percentage-point cut in 2025. However, projections are always subject to revision and it remains to be seen how the FOMC moves forward. While the inflation rate at 2.5 per cent is close to the Fed’s medium-term target of 2 per cent, a large reduction in the policy interest rate will run the risk of inflation getting sticky above the target, something the Fed will want to avoid.

In this context, it is important to note this easing cycle is markedly different from the usual. Since the economy is not in any kind of distress, lower interest rates could increase spending relatively quickly. Further, Mr Powell termed the rate decision a calibrated attempt to take the policy rate to the neutral rate. The neutral rate — a policy rate that is neither restrictive nor accommodative — was said to be around 2.5 per cent before the pandemic but has arguably increased since, partly because of a structural increase in the US Budget deficit. According to one estimate, it ranges between 3.5 per cent and 4.8 per cent, which could limit the scope of rate reduction.

Although the Bank of England and the European Central Bank have also eased policy rates recently, global financial markets and capital flows are more influenced by the Fed’s actions. A lower policy rate will be expected to ease financial conditions, which has been happening for a while in anticipation. However, again, this easing cycle will be different because the policy rate is expected to settle much above the near-zero level, where it remained for a significant period since the global financial crisis. Global capital flows may also remain comparatively constrained because of the structurally higher needs of the US government’s deficit financing. India had weathered the Fed-tightening storm relatively well because of substantial foreign-exchange reserves and the deft handling of the currency by the Reserve Bank of India (RBI). With the Fed’s easing cycle underway, the RBI will need to ensure that capital flows don’t put unnecessary upward pressure on the rupee, which would affect the competitiveness of India’s tradable sectors. In terms of policy, the RBI will be expected to remain focused on aligning the inflation rate with the target of 4 per cent on a durable basis.