The two-day meeting of the US Federal Reserve will end on Wednesday, lifting the suspense on the much-awaited interest rate changes.
For weeks now, markets have been anticipating a reduction in interest rates, even though the magnitude remains uncertain. While many anticipate a more conservative 25 basis point cut, some analysts say they won’t be surprised by a 50 bps reduction.
The last rate hike
The US Federal Reserve last increased interest rates in July 2023. This was a 0.25 percentage point increase, bringing the rates to the current 5.25-5.5 percent range. That time, this was the highest interest rate range in 22 years. When the Fed finally cuts rates tomorrow, it will be the first interest rate cut since March 2020.
Why the Fed is likely to reduce interest rates
Here are three reasons:
1. Economic growth
The U.S. economy has continued to show resilience despite high interest rates.
The U.S. economy grew at a healthy 3 percent annual pace – an upward revision from an initial 2.8 percent estimate – in the second quarter of 2024, fuelled by strong consumer spending and business investment. The Commerce Department had previously estimated that the nation’s gross domestic product – the total output of goods and services – expanded at a 2.8 percent rate from April through June.
A strong economy that has weathered high interest rates, allaying, at least temporarily, fears of a recession, is perhaps the strongest reason for the Fed to start the cycle of reducing interest rates.
2. Unemployment rate
Unemployment rate in the country has remained high, signaling a weak jobs market, even though it has shown signs of improvement lately.
The Bureau of Labor Statistics (BLS) reported that the U.S. economy added 142,000 jobs in August 2024, 28,000 more than in July. That said, job growth over the prior two months was revised down by 89,000 jobs. Meanwhile, private payrolls increased by 118,000.
The unemployment rate fell a tenth of a percent to 4.2 percent, driven by a reversal of the temporary layoffs that were present in the July jobs report.
“The August employment report reinforces the view that the U.S. labor market is slowing but not breaking. It also appears that the ‘hard landing’ sell-off following the July jobs report was perhaps an overreaction,” JP Morgan said in a report.
The US Federal Reserve may be tempted to lower interest rates to encourage job creation in a weak market, thereby boosting consumer spending.
3. Inflation
US inflation has been on the decline of late. The Consumer Price Index (CPI) rose 2.5 percent year-over-year in August, a significant reduction compared to the previous months. This cooling inflation has opened the door for the US Federal Reserve to potentially cut interest rates, signaling a shift in monetary policy.
Another significant contributor has been consumer spending, which remained strong.
The central bank’s favored inflation gauge – the personal consumption expenditures index, or PCE – rose at a 2.5 percent annual rate last quarter, down from 3.4 percent in the first quarter of the year. Excluding volatile food and energy prices, core PCE inflation grew at a 2.7 percent pace, down from 3.2 percent from January to March.
At the same time, private inventory investment remain strong, with businesses increasing their inventory levels. However, while the overall inflation rate has improved, some concerns remain, especially sectors like housing and services. Home sales dropped for a fifth straight month in August, falling to their lowest level since 2010.
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