After 4 Years, Why Did the Fed Decide to Cut Rates?

On the early morning of September 19th, Beijing time, the Federal Reserve announced a 50 basis point cut to the target range of the federal funds rate, bringing it down to between 4.75% and 5.00%.

This is the first interest rate cut by the Federal Reserve since March 2020, and the magnitude of the cut exceeded the forecasts of most economists.

It also signifies a shift from a tightening to an easing monetary policy cycle.

On the first day after the rate cut, major global equity assets all posted positive performances.

Spot gold surged 1% during the day, briefly returning above $2590, but failed to hold its position there, closing up 1.07% at $2586.56 per ounce.

Meanwhile, the two major U.S. stock indices hit new historical highs, with the Nikkei 225 and Hang Seng Index both rising more than 2%.

Concurrently, WTI crude oil rose as much as 3% during the day and broke through the $70 mark, closing up 2.85% at $71.03 per barrel; Brent crude closed up 2.42% at $74.11 per barrel.

Thanks to the U.S. dollar index rising and then falling, the offshore RMB exchange rate also reached a recent high.

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However, the Federal Reserve's interest rate cut decision is a complex balancing act, and how this unexpected adjustment will affect the domestic economy still needs time to verify.

How to understand the unconventional 50BP reduction historically, this 50 basis point rate cut is much more than the market expected.

Referring to six typical easing cycles in September 1984, June 1989, July 1995, January 2001, September 2007, and August 2019, only the first cuts in 2001 and 2007 were 50BP, which corresponded to the bursting of the internet bubble and the global financial crisis, two profound crisis events.

The background of this rate cut is that economic data is under pressure to weaken, with the unemployment rate rising from 3.80% in March 2024 to 4.30% in July, triggering the "recession signal" of the Sam rule.

Although it fell slightly to 4.20% in August, it still maintains an upward trend overall.

In the short term, the process of the U.S. labor market shifting from a basic balance to a relaxation may continue, which is the basis for the Federal Reserve's dovish policy stance.

At the same time, the ISM manufacturing PMI has been in the contraction range for five consecutive months, and the Federal Reserve has also lowered its GDP growth forecast for this year from 2.1% to 2.0%.

From this perspective, this round of rate cuts is likely to be a preemptive rate cut.

However, it cannot be ruled out that there will be a significant internal or external shock to the United States, and the preemptive rate cut may turn into a relief rate cut.

The Federal Reserve's dot plot shows that the Federal Reserve's baseline scenario for rate cuts this year has been raised from 75bp to 100bp, the rate cut expectation for next year remains at 100bp, and the terminal rate has been raised from 2.8% to 2.9%.

Secondly, this 50bp rate cut is also a compensation for not cutting rates in July.

Looking back, the Federal Reserve should have taken rate-cutting action in July, but it decided to stay put at that time, so the Federal Reserve chose to make up for this gap by cutting rates by 50bp in one go in September.

Powell also pointed out in the press conference: "If the Federal Reserve had seen the non-farm employment report released a few days after the July resolution a few days earlier, it might have cut rates for the first time at the July interest rate meeting," but also said: "Given the outlook, we believe we are not lagging in the necessity of rate cuts."

In addition, looking at the voting situation, the shift in the Federal Reserve's attitude is a high consensus within its own ranks.

For example, regarding this 50BP rate cut, only Michelle W. Bowman among the 19 members opposed, advocating for a 25BP rate cut.

Moreover, compared with the dot plot released in June, this dot plot shows that the current Federal Reserve officials have greatly increased their expectations for rate cuts in the next three years.

Among the 19 officials, there are 9 who believe that the cumulative rate cut within 2024 will not exceed 75BP, and the remaining 10 believe that the cumulative rate cut will not be less than 100BP, that is, most officials imply that there will be only 1-2 rate cuts of 25BP each in the other two meetings of the year.

In general, the Federal Reserve has played a hedge, on the one hand, the first rate cut is more than expected, on the other hand, through the dot plot, the future rate cut expectations are very tight.

Powell said that the subsequent rate cut path will be based on the way the economy evolves.

If appropriate, the Federal Reserve can speed up, slow down or even pause rate cuts, implying that investors cannot take the 50BP rate cut as the norm for subsequent Federal Reserve operations.

Why did the Federal Reserve turn to "dove" at this time?

Looking at the changes in the Federal Reserve's forecasts for the future rate cuts in June and September this year, this rate cut has a typical "dove" feature.

The reason is that a large rate cut can increase the possibility of a soft landing for the economy in the short term.

Historical soft landings are usually accompanied by rate cuts, because moderate adjustments to monetary policy after significant tightening can help avoid excessive tightening.

As mentioned earlier, although the U.S. economy is further cooling, the labor market continues to cool, and inflation data continues to fall, some economic data still has resilience, such as the University of Michigan's consumer confidence index in September was 69, expected 68.5, and the final value in August was 67.9.

U.S. retail sales in August rose 0.1% month-on-month, expected to fall 0.2%, and the previous value was revised from a rise of 1.0% to a rise of 1.1%.

Core retail sales rose 0.1% month-on-month, expected to rise 0.2%, and the previous value rose 0.4%.

Although the job market has deteriorated due to supply-side factors such as immigration, the economy is still far from a recession, and the Federal Reserve still has enough policy space to achieve a soft landing.

In addition, from a political perspective, Powell also has his own private interests.

According to Bloomberg, Trump said at a campaign event in Manhattan that the rate cut was "very unusual," either indicating that "the economy is very bad," or else "they are playing politics."

He said in an interview with the U.S. media on the 19th that the rate cut was a "political move to keep someone in office," but it would not work because inflation is so serious.

Harris called the rate cut "good news," promising to reduce prices, and attacked Trump's economic plan.

Although Powell emphasized that the Federal Reserve's decisions are collective decisions, they do not serve any party but all Americans, and will only do what they think is right.

However, from the current election situation, the Federal Reserve and Powell should support the establishment, the Democratic Party, and Harris.

He tried to maintain a vague neutral position when Biden's support rate was behind Trump, and his attitude quickly turned to a dove when Harris took over from Biden and his support rate exceeded Trump.

Now Harris and Trump's election situation is in a stalemate, Trump's policy stance is very unfriendly to the Federal Reserve, such as comprehensive tariffs and restrictions on immigration will lead to inflation.

In addition, Trump himself has a lot of opinions on Powell.

As the interest rate hike policy continues, Trump not only criticized Powell in public places but also tried to pressure him to change his policy direction in various ways, but Powell has always been unmoved.

Trump's senior adviser Stephen Moore said in an interview with Yahoo Finance's "Opening Bid" podcast last month that when Powell's term ends, "we will look for new people, maybe Judy Shelton, Larry Kudlow, Arthur Laffer, or others who are more in line with his economic philosophy."

It can be seen that the grudges between Powell and Trump may continue to ferment, and this process not only affects the direction of the Federal Reserve's policy but also brings a lot of variables to the global market.

What is the impact on the domestic market?

From a macro perspective, the adjustment of the Federal Reserve's policy is an important external risk source affecting the global financial market, mainly transmitted through three mechanisms: the interest rate channel, the exchange rate channel, and the expectation channel.

The federal funds rate mainly affects the global financial market through the interest rate channel and the exchange rate channel, and the tone of monetary policy mainly affects the financial market through the expectation channel.

The interest rate channel refers to the fact that the Federal Reserve's reduction of the federal funds rate will directly reduce market interest rates, and the profit-seeking nature of capital will drive capital to flow out of the United States and turn to other economies.

The exchange rate channel refers to the fact that when the Federal Reserve cuts interest rates, the dollar liquidity is loose, the global supply of dollars increases, and the dollar exchange rate weakens, and non-dollar currencies or appreciate relatively to the dollar.

The expectation channel refers to the fact that the Federal Reserve affects the expectations of market participants for future monetary policy through monetary policy communication, thereby changing the expectations for future market interest rates, and ultimately affecting the financial market.

For the domestic market, the Federal Reserve's rate cut, especially a significant rate cut of 50bp, helps to open up policy space.

According to a report by CICC, the current short-term interest rate spread between China and the United States is 320bp.

If we assume that the Federal Reserve's "dot plot" gives a 250bp rate cut space, then it is expected to narrow the spread to 70bp.

On September 5th, at a press conference of the People's Bank of China, it was pointed out that while domestic monetary policy is mainly "self-centered," the People's Bank of China will also closely monitor the adjustment of monetary policy in major developed economies.

However, it should be pointed out that space does not mean necessity.

Under real constraints, the final rate cut is more critical.

If it can be larger, it will have a more positive effect on the market.

In terms of exchange rates, during the Federal Reserve's rate cut cycle, the narrowing of the interest rate spread between the United States and other countries and the phased weakening of the dollar are to some extent helpful to alleviate the pressure of capital outflows from emerging markets.

It is expected that most of the time this year, the U.S. dollar against the renminbi will fluctuate bidirectionally within the range of 7 to 7.2.

In terms of exports, one of the three major engines, is expected to continue to grow.

Under normal circumstances, the appreciation of the renminbi is not conducive to exports, but this time the appreciation of the renminbi is behind the Federal Reserve's rate cut, and the rate cut may stimulate overseas economic growth and boost demand for Chinese products.From a liquidity perspective, the Federal Reserve's interest rate cuts may improve the macro and micro liquidity of A-shares in the medium to short term, aiding their upward trend.

However, this does not necessarily attract a significant inflow of international capital into the Chinese market, as the trajectory of A-shares before and after the Fed's rate cuts is primarily driven by the fundamentals of China's economy.

At present, it might be that only more robust fiscal and monetary policies can change people's expectations.

In the medium to long term, whether market-oriented economic reforms and tax and fiscal system reforms can bring new growth points and efficiency improvements to China's economy may be the fundamental factor determining domestic trends.