Late Wednesday evening India time, the United States Federal Reserve announced a quarter-percentage-point cut in interest rates — the first rate cut in 11 years.
What makes this rate-cut action — the first since the global financial crisis broke in 2008 — more significant is that barely six months previously, the US Fed was increasing interest rates.
Why the rate cut by the Fed?
The Fed has cited concerns about the global economy and muted US inflation among the key reasons for the decision to cut rates, and signalled a readiness to lower borrowing costs further if needed. At the same time, the central bank has underlined that the US economy grew “at a healthy pace” over the first six months of the year.
Financial markets had expected the quarter-percentage-point rate cut, which lowered the US central bank’s benchmark overnight lending rate to a target range of 2%-2.25%.
Does the cut indicate a shift in policy?
The cut in policy rates follows months of pressure from US President Donald Trump, who has been pushing the American central bank for a cut in rates to stoke growth. The Federal Open Market Committee (FOMC) is a panel within the Fed that is responsible for setting policy rates.
What will be the impact on emerging market economies, including India?
Theoretically, a rate cut in the US should be positive for emerging market economies (EMEs), especially from a debt market perspective. Emerging economies such as India tend to have higher inflation and, thereby, higher interest rates than those in developed countries such as the US and Europe. As a result, FIIs would want to borrow money in the US at low interest rates in dollar terms, and then invest that money in bonds of emerging countries such as India in rupee terms to earn a higher rate of interest.
When the US Fed cuts its interest rates, the difference between the interest rates of the two countries increases, thus making India more attractive for the currency carry trade.
A rate cut by the Fed would also mean a greater impetus to growth in the US, which could be positive news for global growth. But this could also translate into more equity investments in the US, which could temper investor enthusiasm for emerging market economies in a proportionate manner.
How did the stock markets react; why?
Indian stocks tanked on Thursday. While domestic factors such as dismal July car sales data and slower GDP growth projections played a role in the selloff, one of the major factors was US fed rate cut.
Thursday’s sell-off dragged benchmark indices to fresh five-month lows, with the BSE Sensex slipping below the 37,000 mark. The broader Nifty50, too, breached the 11,000 mark in the intra-day trade.