Federal Reserve cuts interest rates by 50 basis points, now between 4.75% and 5%; first drop since March 2020

The US Federal Reserve has reduced interest rates by 50 basis points. The interest rate will now be between 4.75% and 5%. The last time the Fed reduced rates was in March 2020. Between March 2022 and July 2023, the US central bank increased rates 11 times to curb inflation.

Last year, the Federal Reserve kept interest rates unchanged for the third consecutive time in its policy decision. On July 26, 2023, as per market expectations, the Fed maintained the policy rate in the range of 5.25%-5.5%.

However, the Fed has also indicated that there could be a rate cut in 2024, potentially lowering it to 4.6%. The Fed started raising rates in March 2022 to combat inflation. By July of last year, these rates had reached the highest levels in 23 years.

What Could Be the Impact of a Rate Cut?

Stock market analysts believe that a significant rate cut could lead to a bullish trend in the stock market. Excessive cuts could also raise concerns about the economic health of the US, which could lower investor confidence. A small cut (around 25bps) might cause disappointment in the market, as it expects a larger cut in interest rates. Delaying the rate cut could slow down the job market. Therefore, the central bank will need to proceed cautiously. Reports indicate that Fed officials have signaled that labor market data will play a more significant role in their decisions than inflation.

The Policy Rate is a Powerful Tool Against Inflation

Every central bank has a powerful tool in the form of the policy rate to fight inflation. When inflation is high, the central bank tries to reduce the money supply in the economy by raising the policy rate.

If the policy rate remains high, the loans that banks receive from the central bank become expensive. In turn, banks raise the cost of loans for their customers. This reduces the money supply in the economy. When the money supply decreases, demand falls, and inflation drops.

Similarly, when the economy is going through a bad phase, more money flow is needed for recovery. In such cases, the central bank lowers the policy rate. This makes loans from the central bank cheaper for banks, and customers also receive loans at lower rates.