Why the Fed is set to cut interest rates and what it means

The The Federal Reserve (Fed) is expected to cut interest rates Wednesday. This is it a crucial event as it directly affects families and businesses in the United States (US) – but also abroad given the importance of the US as the world’s largest economy.

Interest is the price you pay when you borrow money: personal loans, business loans, student loans, credit cards, mortgages, … the amount of interest on all of these ultimately depends on the level of the federal funds rate which is set by Fed.

The Fed decides the level of interest rates independently, meaning that its decisions are not subject to approval by the US federal government. Setting interest rates is one of the Fed’s most powerful tools because it directly affects the economy: high interest rates can make borrowing more expensive for households and businesses, while lower rates can make it cheaper and easier to get a loan approved.

What is a rate cut and why is it important?

A cut in interest rates means the Fed is reducing borrowing costs. It is the first time the US central bank will do so since March 2020, when the first wave of the coronavirus pandemic hit and a series of lockdowns were introduced to mitigate the spread of the virus, causing a shock to the economy.

In addition to being the first such move in more than four years, the rate cut will come after a series of steep increases in 2022 and 2023. We’ll get into that later, but the cut may mark a turning point, representing the end. of a bullish cycle and the start of a new one where interest rates could steadily decline.

The evolution of interest rates in the United States since 2019. Source: FXStreet.

But why is this important?

Since the rate level set by the Fed virtually influences the amount of interest on any loan, lower rates mean that consumers and businesses will be able to borrow more cheaply than before.

So, good news for your pocket.

Now, think big. Lower rates can encourage thousands of people to take out a loan to buy big-ticket items and pay less interest for her (and so you can spend this money elsewhere). The same goes for businesswhich can get cheaper funds to invest in expansion. That is why lower rates tend to help the economy grow.

Will the Fed cut interest rates?

Yes, it will be. Economists and analysts who follow the Fed closely believe now is the right time to cut interest rates after the sharp rate hikes seen in recent years.

Moreover, several members of the Federal Open Market Committee (FOMC) – the group of people tasked with deciding interest rates – have also explicitly stated that they see a rate cut in September as appropriate.

Federal Reserve Chairman Jerome Powell said in August that “the time has come for policy to adjust.” Put simply, Powell meant that he and his FOMC colleagues share the view that now is the right time to cut interest rates.

Why is the Fed cutting rates now?

As the US central bank, the Fed has a dual mandate: to promote maximum employment and stable prices.

As of 2022, the run of inflation seen in the US or rapid price growth prompted the Fed to act quickly as one of its mandates – price stability – was at risk. With prices rising sharply, the central bank decided to quickly raise interest rates with the aim of cooling the economy and keeping price rises at bay.

Prices rose to a peak of 9.1% in June 2022. Since then, the inflation rate has gradually declined and stood at 2.5% in August 2024, very close to the Fed’s 2% target.

The evolution of annual inflation in the United States from 2021, as measured by the CPI. Source: FXStreet.

With US price increases more under control, Fed inflation worries fade. by itself this reason would already be enough to reduce interest rates.

However, in recent times, some concerns have arisen about the Fed’s other mandate: to promoting maximum jobs.

The US labor market has been hot since the pandemic reopened, with employers steadily hiring new workers to meet strong demand for goods and services. The US unemployment rate – which measures the number of people out of work as a percentage of the total labor force – fell to 3.4% in January 2023, the lowest level in more than five decades.

But labor market conditions are slightly different now. The The US economy continues to add jobs each month, but at a slower pace than before. The unemployment rate stands at 4.2%, which is still low by historical standards, but has risen significantly in recent months.

Fed Chairman Jerome Powell said on the matter that “we (the Fed) will do everything we can to support a strong labor market.” In other words, Powell specified that The Fed would cut interest rates if needed to keep employment high.

How much is the Fed expected to cut rates?

It is not clear – and this is one of the main question marks of the upcoming Fed meeting.

US interest rates are currently in a target range that extends between 5.25% and 5.5%. Economists, investors and analysts constantly try to predict how this level will change in the near future, because it is the key to determining the wealth of the economy and therefore the valuation of currencies, stocks, commodities or cryptocurrencies.

Currently, the markets are betting on two scenarios for the Wednesday meeting. In the first and most likely scenario – according to investors – the The Fed will cut interest rates by half a percentage point to a range between 4.75% and 5%.

The another option is that the Fed opts for a smaller cut, cutting rates by a quarter of a percentage point to 5%-5.25%.

Market price probabilities of Fed rate target for September. Source: CME Group FedWatch tool.

In normal cycles, the Fed tends to change rates by a quarter of a percentage point. However, bigger moves are possible if the central bank feels it needs to move faster. For example, during the outbreak of the coronavirus pandemic, the Fed cut interest rates by a full percentage point in less than a month to support the economy.

Similarly, the Fed has raised rates very aggressively several times in recent years in an effort to quell inflation.

Uncertainty over the size of the cut makes this meeting particularly interesting for investors.

“The Fed likes to broadcast its moves in advance, and this time is different,” says Yohay Elam, Premium Product Manager at FXStreet. “With about a 50-50 chance of either a standard 25bps cut or a big 50bps cut, the decision is the most important market. Basically, equities and gold will rise by a 50bps discount, while the US dollar would benefit from a 25bps discount,” he said.

Will the Fed continue to cut rates, or is it a one-off?

Fed officials repeatedly say the central bank is “data dependent,” meaning any action in the the future will depend on the data gathered about the state of the US economy.

Typically, the Fed keeps an eye on data related to both inflation and the labor market. However, in the current context, the latter gains more importance as price growth already appears under control and, as explained, there are growing signs that labor market conditions may deteriorate.

Investors expect the Fed to cut interest rates further in its two scheduled meetings before the end of the year. (except for Wednesday).

Fed officials have not confirmed any of this, but Wednesday’s meeting will also provide a glimpse of what’s to come. Each of the Fed members will give their estimates of where they think interest rates are headed, and that will provide key information about the chances of more cuts in the future.