U.S. Federal Reserve’s Rate Cut and Its Implications

Why in the News “U.S. Federal Reserve “?

Recently, the U.S. Federal Reserve reduced its benchmark interest rates by 50 basis points, marking its first significant cut since the COVID-19 pandemic began. This move indicates a strategic effort to combat inflation while encouraging economic growth.

Note: The Federal Reserve aims to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.

Reasons for the Rate Cut:

• Economic Recovery Post-Pandemic: Initially, the Federal Reserve lowered rates to stimulate the economy after the pandemic. However, as inflation surged due to factors like global supply chain disruptions from the Russia-Ukraine conflict, it raised rates to manage rising prices.
• Moderation of Inflation: By mid-2023, inflation began stabilizing, approaching the Federal Reserve’s target of 2%. Recent employment data showed that high interest rates were negatively affecting job growth, with U.S. unemployment rising to 4.2% in August 2024. This raised concerns about a potential recession, prompting the Fed to focus on job creation alongside price stability.
• Dual Mandate: The Federal Reserve operates under a dual mandate to maintain stable prices and maximize employment. It became evident that a rate cut would help balance these objectives.

Implications for the U.S.:

• By lowering rates, the U.S. aims to address inflationary pressures while maintaining a target rate of around 2%, seeking a “soft landing” for the economy.
• Lower interest rates generally reduce borrowing costs for individuals and businesses. With rising unemployment, the Fed is prioritizing job creation along with price stability, potentially leading to economic expansion.

Relationship Between Inflation and Unemployment:

• Inverse Correlation: Inflation and unemployment typically exhibit an inverse relationship; when one increases, the other decreases. In low unemployment periods, wage inflation tends to rise as employers offer higher wages, leading to increased prices. Conversely, high unemployment results in stagnant wage growth and lower inflation.
• Phillips Curve: This economic theory, proposed by A.W. Phillips in the 1950s, explains the inverse relationship between unemployment and inflation. It suggests that higher labor demand during low unemployment leads to higher wages, driving inflation. This model has been influential in monetary policy, particularly in balancing inflation and employment.

Impact on India from the Federal Reserve Rate Cut:

• Effects on Emerging Markets: A lower U.S. interest rate enhances the attractiveness of investing in countries like India through carry trades, where investors borrow in the U.S. at low rates and invest where returns are higher.
• Limited Impact: India’s Chief Economic Adviser noted that while the rate cut may lower the dollar cost of capital and boost liquidity, it should not be seen as a standalone solution for global economic improvement.
• Increased Foreign Investment: Lower U.S. rates could encourage global investors to borrow and invest in India, potentially leading to more Foreign Direct Investment (FDI) and providing essential capital for the Indian economy.
• Stock Market Sentiment: The rate cut has generated considerable interest in the Indian stock market, reflecting positive investor sentiment despite global uncertainties.
• Crude Oil Prices: A weaker U.S. dollar makes oil cheaper for other currency holders, which may increase demand and lead to higher prices, raising India’s energy import costs and potentially reigniting inflation.
• Currency Exchange Rates: A weakening U.S. dollar could negatively impact Indian exporters while benefiting importers.
• RBI’s Response: The Reserve Bank of India (RBI) may feel pressure to cut interest rates, though it operates under different inflation targets and economic mandates compared to the Federal Reserve, focusing more on GDP growth.

Federal Tapering:

• Federal tapering involves gradually reducing large-scale asset purchases, a tool often used during economic crises to stimulate the economy. This process aims to withdraw some economic stimulus, transitioning to a more normalized monetary policy.

India’s Repo Rate:

• The RBI decided to keep the policy repo rate unchanged at 6.50% during its 50th Monetary Policy Committee (MPC) meeting. This decision reflects the committee’s strategy to manage inflation while supporting economic growth, with a primary objective of aligning inflation with the target rate of 4.0%, within a tolerance band of +/- 2%.

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