The Federal Reserve (Fed) cut US interest rates by 0.25% last week, bringing them down to a target range of 4.0 to 4.25%. This move followed a nine-month pause in interest rate cuts as the Fed grappled with inflation and unemployment figures. But why has the Fed cut interest rates now, what does it mean for the US, and why does it matter globally?
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Why did the Fed cut interest rates?
The Fed’s dual mandate requires it to use interest rates to keep inflation low and to keep the US close to full employment.
If inflation is too high, the Fed would normally raise interest rates and, if the labour market is not creating enough jobs, it would typically cut interest rates.
This year, both have been the case.
US inflation has risen, partly due to Trump’s tariffs on imports, meanwhile, job creation has stalled with the unemployment rate grinding higher. The Fed’s dilemma has been whether higher inflation or rising unemployment poses the greater risk to the US economy.
Cutting rates now signals that the Fed sees jobs weakness as the key risk right now.
What it means for housing
The hope is that, after three years of relatively high interest rates, a cut will reduce borrowing costs, encouraging companies to hire more workers and invest in their businesses, while giving households more disposable income.
The housing market in the US has been particularly weak over the period of higher interest rates. Sales of existing homes have declined from an annual rate of 6.43m properties in January 2022 to 4.08m in January 2023, where they have broadly stayed.
The key reason being the doubling of mortgage rates since 2021. This has made homes unaffordable for many new buyers and locked many who borrowed before 2022 into their existing homes. While the Fed’s rate cut on its own improves housing affordability only slightly, it’s a move in the right direction for American families.
What it means for financial markets
As well as being helpful for the housing market, interest rate cuts might also benefit areas of the stock market that have been left behind since 2022.
Over the last few years, much of the return from the US stock market has been driven by tech. Companies like computer chip (semiconductor) manufacturers, like Nvidia and Broadcom, and large software and computer services businesses, including Microsoft, Alphabet and Meta Platforms.
Sectors like real estate and personal goods have materially underperformed the wider market. Lower interest rates might improve their fortunes by cutting the interest costs of their debt and giving customers more to spend.
However, there will be losers from lower interest rates.
The first group is savers, in particular, older people holding a lot of their wealth in cash. However, they could move their savings into other opportunities like government bonds, mortgage-backed securities and corporate debt. Although yields on bonds that mature in the next few years have already fallen as the market prices in interest rate cuts, these can still perform well if rates fall by more than expected. This could be possible if the Fed bows to pressure from President Trump.
Another group that might lose out is highly profitable large companies, the major financial and technology businesses that have enjoyed rapid earnings growth over recent years, accumulating a lot of cash.
However, banks may now increase their lending while many big technology firms are already using their cash to invest in artificial intelligence. In addition, these businesses tend to have high overseas earnings, so can benefit if lower interest rates cause the US dollar to weaken further.
Why it matters beyond the US
Although the Fed’s focus is on the US economy, its decisions influence global interest rates and asset prices.
Overseas central banks will be mindful that lower US interest rates can mean a weaker US dollar, which could make their countries’ exports to the US less competitive. This is because it costs buyers more dollars than before to purchase foreign products. Such a situation might prompt some to follow the Fed in cutting interest rates to maintain their economic competitiveness.
Lower American interest rates and a weaker dollar might also encourage investors to reallocate some of their money away from the US and into overseas assets. Relatively high yielding bonds, like emerging markets debt or, closer to home, UK gilts might appeal to international investors looking for better returns.
In summary, this interest rate cut by the Federal Reserve is intended to boost the US economy and might feed through to financial markets. The size and significance of the US economy and its markets, coupled with the ability of capital to move around the world, means that the effects may also be felt beyond the American shores.
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