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Fed Announces its Biggest Interest Rate Cut in Four Years

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An overview of the situation

To everyone’s great surprise, especially the insiders, on September 18, 2024, the American Fed (Federal Reserve System) announced its first interest rate cut in more than four years. Therefore, for the first time since the start of the pandemic, the central bank has decided to lower the interest rates by a 0.5 percentage points, into a range between 4.75% and 5%. Despite various analysts predicting a smaller cut, the central bank has put in place its largest cut since March 16, 2020, with an additional cut (albeit potential) forecast to be made by the end of 2024. Before moving on: what is an interest rate? How the decisions taken by the Fed on interest rates affect the borrowers and the whole community? Both these questions find an effective answer after stating the definition of an interest rate.

The interest rate and the federal funds rate

In general, according to Cambridge Dictionary, an interest rate is ‘’the amount - based on the percentage of the principal loan - charged by a bank or financial company when money is borrowed, or the amount paid when money is kept in an account’’.

From a more technical point of view, a federal funds rate is the interest rate at which depository institutions trade federal funds with each other overnight. It is set by the Federal Open Market Committee (FOMC).

Normally, when a bank has an excess of cash, it will lend money to another bank, which needs to raise liquidity. The rate that the borrowing institution pays to the lending institution is assessed after an agreement between the two banks: the weight average rate for these types of negotiations takes the name of effective federal funds rate. The federal funds rate is the central interest rate in the U.S. financial market. It also influences other interest rates, such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Besides that, the federal funds rate can also indirectly influence longer-term interest rates such as loans and savings. Those types of operations are those under major consideration of small investors.

How the federal funds rate is determined

The federal funds rate is essentially determined by the market, but it is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.

More specifically, the Federal Reserve influences the effective federal funds rate by buying and selling government bonds (debt securities issued by a government to support spending and obligations). Firstly, the Federal Reserve can decrease liquidity by selling government bonds, raising the federal funds rate, following a shortage of liquidity for trade. On the other hand, the Federal Reserve may also increase liquidity by buying government bonds, consequently decreasing the federal funds rate, due to an excess of liquidity of banks for trade.

The reason why increasing or decreasing the rate

First of all, it is important to note that the key decisions about interest rates are taken by a committee within the Federal Reserve System: The Federal Open Market Committee (FOMC). Its members meet eight times a year to determine the federal funds target rate. Their main resolutions are based on the state of the economy: the decision to buy or sell bonds is based on the main economic parameters of the country. For instance, if the FOMC believes the economy is growing too fast and inflation rates are uneven with their criteria, the Committee may set a higher federal funds rate target to mitigate economic activity.

In the opposing scenario, the FOMC may set a lower federal funds rate target to encourage greater economic activity. Therefore, the FOMC must look at the current economic landscape to determine the best course of monetary policy to maximize the complex economic growth. In making its monetary policy decisions, the FOMC considers a series of economic data, like trends in prices and salaries, employment rate, average consumer spending and income, business investments as well as foreign and internal exchange markets.

How the rate affects borrowers and the community

Investors keep a close watch on the federal funds rate: on average, the stock market typically reacts very strongly to possible changes in the target rate. Both domestic and international investors use it to gauge the future outlook of the U.S. economy and adjust their portfolios accordingly. As a result, changes in the federal funds rate often result in fluctuations in stock markets in the United States and also outside the American borders.

The rate also indirectly influences short-term interest rates, even for the most basic things from home and auto loans to credit and debit cards, as lenders typically determine their rates based on the prime lending rate.

Political Reactions

The long-awaited announcement by the Fed has come in the middle of the American electoral campaign and has triggered different reactions in the two opposing sides - Democrats and Republicans- as well as in their candidates. Both Vice President Kamala Harris and former President Donald Trump have addressed the matter, expressing their opinion on the topic.

On the one hand, the Democrat candidate has immediately welcomed the update as a ‘’welcome news’’, which will help citizens facing high prices, following no interest rate decrease for the past four years. On the other side of the spectrum, the tycoon and his running mate -Senator JD Vance - have pointed out that this move shows how ‘’the economy is very bad’’ (at the moment), hugely criticizing Fed Chairman Jerome Powell's move in the process. However, the former president’s statements have not ended in that public address.

‘’It was a political move’’ Donald Trump said during an interview with NewsMax. "Most people thought it was going to be half of that number, which probably would have been the right thing to do," he added later, emphasizing how the Fed’s interest rate cut should have been in the 0.25 percent range. As a result of that, the former president's remarks show how he strongly believes that the Fed's first interest rate cut in four years was just a way to help the Democratic administration and opposing candidate Harris for November elections.

The projection of the federal funds rate

Projections suggest further reductions in the coming years, with the rate expected to fall. These cuts aim to support the economy by balancing inflation control with upcoming growth. In 2025 the rate is expected to drop further to 3.4%, while in 2026 a decrease to 2.9% is projected. In 2027 the rate is likely to remain steady from the previous year.

Also in terms of future projections, the long-run rate estimate (also known as the "terminal rate") increased slightly higher to 2.9% from the 2.8% interest set at the previous meeting of the Committee, and is up from 2.5% from the year-ago report. The gradual rise of the estimated rate leading to the belief that the economy is likely to grow at a stronger pace in the near future than it did in the past.

Key Differences Between U.S. and EU Approaches after 2020

It is important to clarify how both regions maintained low rates leading up to 2020, with the U.S. rate dropping close to 0%, while the EU rate remained near 0%: the Covid-19 pandemic led to an economic downturn, prompting central banks to implement unprecedented measures to stabilize their economies. In 2022 and 2023, both economies significantly increased their rates in response to inflationary pressures, with the U.S. rate peaking at 5.33%, and the EU reaching above 4%. After 2023, both rates begin a steady decline, with the U.S. rate projected to fall to 3.4% by 2025, and the EU rate to around 3%. By 2027, the rates are likely to stabilize, converging at approximately 2.9%.

This comparison highlights the varying but eventually converging strategies of these two major economies in managing inflation and economic growth. Whilst, the U.S. shows a more aggressive rate hike post-2021, followed by a faster reduction, the EU maintains a more gradual trajectory with lower peaks but aligns closely with U.S. rates by 2027.