The Impact of the Federal Reserve's Interest Rate Cut on the World

October 18, 2024

About the author

The Federal Reserve's recent decision to cut interest rates by 50 basis points marked an important turning point in US monetary policy. This move has ended two years of continuous interest rate hikes, signaling further easing of monetary policy in the future. The interest rate cut will gradually reduce the attractiveness of financial assets denominated in the US dollar, leading to a depreciation of the US dollar. Since the US dollar is the predominant currency in the international monetary system, the Federal Reserve's monetary policy will have an enormous impact on the flow of the US dollar and global capital, thus affecting the world economy.

Most practitioners in the US capital market believe the Federal Reserve's interest rate cut in September is only the beginning of a broader rate-cutting cycle. The pace of future rate cuts may accelerate, and its spillover effects on the world economy will become increasingly obvious.

Why Cut Interest Rates?

Before the Federal Reserve announced the interest rate cut, there already were rumors circulating in the market. As a result, the prices of oil, gold, US stocks, and commodities had already begun to rise. Since Alan Greenspan became chairman in 1987, the Federal Reserve has been managing monetary policy in accordance with market expectations. Therefore, its decisions to raise or cut interest rates have aligned closely with market expectations.

In recent years, the Federal Reserve's monetary policy has experienced ups and downs. During the pandemic, the Federal Reserve sharply cut interest rates and made "limitless easing" to provide liquidity to the market. Since 2022, however, interest rates have been raised sharply several times, bringing the benchmark rate to between 5.25% and 5.5%. This rapid increase has led to liquidity constraints, causing some banks to go bankrupt.

According to revised data from the US Bureau of Labor Statistics for March 2024, there were 818,000 fewer jobs than previously reported, indicating that the US economy has begun to decline. Many analysts predicted a high probability of a US recession in 2024, estimating the likelihood at 85%. Such a recession would significantly increase the pressure to cut interest rates. In June 2024, the Federal Reserve conducted a stress test to simulate sharp fluctuations in financial markets. The test assumed that corporate bond spreads would widen, and asset prices would fall sharply. This potential financial market instability could affect the Federal Reserve's policy decisions, pushing it to take more mitigation measures.

The Federal Reserve's decision to cut interest rates came in the context of slowing global economic growth. The economic performance of the United States and the euro area was a concern, and global growth was expected to remain sluggish, with forecasts suggesting it could slow down to 2.4%. Factors such as tight monetary policy and weak demand contributed to this outlook. In response, the Federal Reserve saw gradual interest rate reductions as a way to support economic growth.

Market participants predict that after the Federal Reserve begins to cut interest rates in September, it may lower them three to four times in a row, by about 0.25% each time. However, the Federal Reserve's initial cut of 50 basis points signaled a belief that the economic downturn was accelerating. Without taking drastic measures, the US recession could become even more severe. However, such a sharp rate cut may also heighten public anxiety, and the market's fierce reaction may lead to further financial difficulties. The mass selling of stocks in the market indicated that panic has begun to permeate.

The Impact of the Federal Reserve's Interest Rate Cut on the US Economy

The Federal Reserve's interest rate cut was designed to influence the US capital market, thus directly and indirectly affecting the behavior of different economic agents.

First, interest rate cuts can directly reduce borrowing costs for enterprises, enabling them to obtain loans at more favorable rates. This helps enterprises expand their business, purchase new equipment, or hire more employees, thus improving financial health and growth potential. Reduced costs can also increase profit margins, which in turn promotes overall economic growth. Lower borrowing costs further encourage enterprises to invest and expand. In addition, enterprises can take advantage of lower rates to optimize their financial statements and mitigate short-term financial pressures.

Second, the decline in loan interest rates is likely to boost consumer spending power. Low consumer loan interest rates make borrowing for consumption more attractive, driving up overall consumption levels. For example, low mortgage rates reduce the cost of home loans and increase consumers' disposable income. In addition, low interest rates will discourage saving, which promotes higher spending. This rise in consumer spending supports economic recovery by stimulating market demand.

Third, as the profitability of enterprises improves, this should stimulate a recovery in the stock market. By reducing borrowing costs and increasing consumer demand, interest rate cuts are expected to eventually improve corporate profits, which will positively impact stock prices. However, this effect often takes time to materialize. The impact of interest rate cuts on the bond market is relatively complex. Both short- and long-term bond yields are affected, but the speed and extent of response are different. Short-term bond yields usually decline rapidly, while long-term bond yields will depend on market perceptions of the long-term economic outlook and inflation expectations. Interest rate cuts often steepen the yield curve, meaning short-term interest rates fall more sharply than long-term ones.

Fourth, interest rate cuts usually lead to the depreciation of the US dollar and may encourage capital outflows into markets with higher yields. A weaker dollar enhances the competitiveness of US exports, but it also increases import costs and affects the trade balance. At the same time, capital outflows bring opportunities for emerging markets and developing economies to attract more inflows, though they also face challenges related to interest rates and currency fluctuations.

Additionally, interest rate cuts can indirectly push up house prices as a result of lower mortgage rates. In a low-interest-rate environment, the cost of buying a house is reduced, which stimulates demand and drives up house prices. This pattern has recurred in past rate-cut cycles, although actual increases in house prices also depend on supply-demand dynamics and other market conditions.

The Impact of the US Interest Rate Cut on the World Economy

The Federal Reserve's interest rate cut typically weakens the US dollar, because lower yields reduce the attractiveness of dollar-denominated financial assets. In export-dependent economies, this devaluation can improve competitiveness, boost exports, and promote economic growth. On the contrary, import-dependent economies may face rising import costs, resulting in inflationary pressures and a decline in consumer purchasing power.

Central banks in other countries usually respond to the Federal Reserve's interest rate cuts by relaxing their monetary policies to maintain a competitive exchange rate and manage the domestic economic situation. This synchronous easing can reduce global bond yields and influence investor behavior, encouraging increased risk-taking in stock markets and driving sector shifts. For example, expectations of the Federal Reserve's interest rate cuts may push investors toward sectors like technology and consumer discretionary goods, which tend to benefit more from lower financing costs.

Some time ago, as the Federal Reserve raised interest rates, yields on US Treasury bonds rose, attracting investment back to the United States. However, with the Federal Reserve cutting interest rates and the dollar depreciating, there are significant effects on global bond yields. A decline in US Treasury bond yields usually leads to a decline in global bond yields as well.

 

Different sectors of the global economy react differently to changes in US monetary policy. The technology sector, which is sensitive to stock market fluctuations, has experienced huge changes in profits and output during periods of monetary tightening. The manufacturing sector, which relies heavily on capital investment, is directly affected by financing costs, with tighter policies leading to reduced investment. Meanwhile, the service sector, though less sensitive to exchange rate changes, still plays a crucial role in influencing inflation through labor market dynamics. After the Federal Reserve cuts interest rates, a large amount of capital may flow back to emerging economies, which is beneficial to the financing of unicorn enterprises in the technology industry.

In short, the Federal Reserve's interest rate cut has had a far-reaching and multifaceted impact on global capital markets, emerging economies, exchange rates, and industry performance. These dynamics highlight the interconnectivity of the global financial system and the complex feedback mechanism that helps maintain this complex economic network.

The Impact of the US Interest Rate Cut on the Chinese Market

Given the interrelated nature of the global financial system, the chain reaction of exchange rate adjustments will extend to capital liquidity. Specifically, the reduced attractiveness of US dollar assets following the interest rate cut may prompt international capital to seek higher returns in emerging markets such as China. A return of capital to China would stimulate its financial market, enhance liquidity, and push up the valuation of stocks and bonds. This influx of demand for local securities may also depress domestic real interest rates.

In terms of bilateral trade, the depreciation of the US dollar will cause the appreciation of the RMB, which may weaken the pricing competitiveness of China's export products, thus affecting trade balance and economic policy. However, the Federal Reserve's interest rate cut could also stimulate US market demand, leading to increased consumption of Chinese goods. This could expand China's trade surplus with the United States. Nevertheless, a growing trade surplus may heighten bilateral tensions, with the US potentially responding through policy measures, such as tariff increases, under the next administration.

From a microeconomic perspective, exchange rate fluctuations alter the cost structure of international trade settlements, increasing transaction expenditures for enterprises when foreign exchange rates shift significantly. Companies may face higher hedging costs and risks, which will affect their operational profitability and financial stability. In the end, the Federal Reserve's interest rate cut provides a broader operating space for China to adjust its monetary policy. Theoretically, the expansion of policy space enables China's monetary authorities to implement supportive measures to counter the economic downturn, thus promoting sustained economic growth. These measures usually include expanding credit, reducing borrowing costs, and stimulating economic activities. Of course, the effectiveness of these measures depends on the specific situation.

Therefore, the combined impact of the Federal Reserve's interest rate cut on China's economy and capital markets highlights a complex but strategically advantageous situation, which is conducive to both short-term financial stability and long-term economic consolidation. The exact scope of this impact is subtle and depends on global financial trends, economic policies, and market responses.

China can take measures to respond to changes in the Federal Reserve's monetary policy and the depreciation of the US dollar:

1. After the 2008 global financial crisis, the Federal Reserve primed for a pump and a large amount of international capital flowed into China, which contributed to surges in the stock market and real estate prices, which later posed challenges for China's macroeconomic management. In the future, if international capital flows into China massively again, it's important not to "add fuel to the fire." Authorities should actively caution the public against irrational stock market rises and remain vigilant about financial bubbles.

2. The appreciation of the RMB presents an opportunity for China to create more robust regional supply chains. This could involve shifting some industries from coastal areas to the central and western regions, and relocating simpler processing industries to neighboring countries. By creating a more structured regional supply chain, China can maintain its export competitiveness even in the context of RMB appreciation.

3. The depreciation of the US dollar may cause losses in foreign exchange reserves for various countries, especially in the Global South, leading to financial difficulties. China can seize this moment to promote reforms in the international monetary system. Strengthening cooperation with other BRICS countries, oil-producing countries in the Middle East, and other partners could help lay the foundation for a fairer international monetary system in the future.

 

 

Please note: The above contents only represent the views of the author, and do not necessarily represent the views or positions of Taihe Institute.

 

This article is from the September issue of TI Observer (TIO), which explores the current turbulence in the global economy, analyzing the effects of geopolitical tensions, supply chain fragmentation, development of financialization, hollowing out of the real economy, in order to shed light on future economic transformations. If you are interested in knowing more about the August issue, please click here:

http://en.taiheinstitute.org/UpLoadFile/files/2024/9/30/1810401645ddb395e-0.pdf

 

——————————————

ON TIMES WE FOCUS.

Should you have any questions, please contact us at public@taiheglobal.org