What just happened: Why did the Federal Reserve cut interest rates?

What just happened?

The US Federal Reserve (Fed), easily the largest and most powerful central bank in the world, just decreased its Federal Funds Interest Rate by 50 basis points (bps) to a reference range of 4.75%-5.0%. This is the first time that the US interest rate has been cut since March 2020 and represents a major policy shift for the Fed.

Why did the Fed cut interest rates?

The US Fed, headed by Fed Chairman Jerome Powell, cut interest rates for the first time in four years in order to alleviate pressure underpinning the US economy and help keep the largest economic region in the world healthy. Interest rates impact a wide range of economic aspects, including how much it costs to borrow money to finance business operations.

With interest rates easing, businesses may be more inclined to step up their pace of borrowing and explore more hiring and production activities. Also, consumers may be more inclined to increase their level of spending on a credit basis, both because it will be slightly easier to obtain bank-funded credit, and also because saving their money will have a slightly less-attractive rate of return versus going ahead and spending it. In this way, central banks can discourage consumers from actively saving more money than they otherwise would have by making the rate of return on savings less attractive, pushing more money into the domestic economy.

As the US central bank, the Federal Reserve has a dual mandate: control the rate of domestic inflation using a variety of policy tools, and also maintain stable employment numbers within the US. Since falling interest rates tend to have an immediately inflationary effect, the Fed needs to be careful about how fast and how much they raise or lower interset rates.

September's rate cut implies that the Fed believes it has successfully tamed US consumer inflation, and expects headline price growth figures to continue easing back toward the Fed's internal goal of 2% YoY inflation.

US employment figures also play a role in Fed decision-making on interest rates, as too high of a reference rate for too long could discourage business activity to the point that a wide sweep of layoffs could force a hiccup into the economy, increasing the likelihood of a recession.

What happens next?

With the Fed’s first rate cut in four years finally out of the way, investors will be immediately pivoting to guess whether the Fed will cut rates again when the central bank gathers on November 7 to deliver another rate call. It is still too early to tell what the Fed’s next move is going to be, and policymakers will want to wait and see what the next few batches of economic data say before making any decisions a little under two months from now.