Why is the Fed set to cut rates and what does that mean for markets?

The Federal Reserve (Fed) is expected to cut interest rates on Wednesday. This is a crucial event as it directly affects families and businesses in the United States (US) – but also abroad given the importance of the US as the world’s largest economy.

The interest is the price to pay when borrowing money: personal loans, business loans, student loans, credit cards, mortgages,...the amount of interest in all these ultimately depends on the level of the federal funds rate that is set by the Fed.

The Fed decides the level of interest rates independently, meaning that its decisions aren’t subject to approval by the US federal government. Setting interest rates is one of the Fed’s most powerful tools as it directly affects the economy: high interest rates can make borrowing money more expensive for households and businesses, while lower rates can make it cheaper and easier to get a loan approved.

What does a rate cut mean and why is it important?

A cut in interest rates means that the Fed reduces borrowing costs. This is the first time the US central bank will do so since March 2020, when the first wave of the coronavirus pandemic hit and a series of lockdowns were introduced to mitigate the spread of the virus, causing a shock to the economy.

Apart from being the first such move in more than four years, the interest-rate cut will come after a series of sharp increases during 2022 and 2023. We will go into this later, but the cut potentially marks a turning point, representing the end of a cycle of increases and the beginning of a new one in which interest rates could consistently go down.

Evolution of interest rates in the United States since 2019. Source: FXStreet.

But, why is this important?

As the rate level set by the Fed basically influences the amount of interest in any loan, lower rates mean consumers and firms will be able to take loans at a cheaper price than before.

So, good news for your pocket.

Now, think big. Lower rates can encourage thousands of people to take a loan to buy big-ticket items and pay less interest for it (and thus be able to spend this money somewhere else). The same applies to businesses, which can get cheaper funds to invest in expansion. This is why lower rates tend to help the economy grow.

Will the Fed cut interest rates?

Yes, it will. Economists and analysts who closely follow the Fed consider that it is now the right time to cut interest rates after the sharp increases in rates seen over the past few years.

Moreover, several members of the Federal Open Market Committee (FOMC) – the group of people in charge of deciding on interest rates – have also explicitly said they see a rate cut as appropriate in September.

The Federal Reserve Chairman, Jerome Powell, said in August that “the time has come for policy to adjust.” In plain words, Powell meant that he and his colleagues at the FOMC share the view that it is the right moment to cut interest rates.

Why does the Fed cut rates now?

As the US central bank, the Fed has a dual mandate: to promote maximum employment and stable prices.

Since 2022, the inflation rout seen in the US, or the quick rise in prices, led the Fed to act swiftly because one of its mandates – price stability – was at risk. With prices rising sharply, the central bank decided to quickly lift interest rates with the aim to cool down the economy and keep price rises at bay.

Prices rose at a peak of 9.1% in June 2022. Since then, the inflation rate has gradually declined and stood at 2.5% in August 2024, very close to the 2% target set by the Fed.

Evolution of annual inflation in the United States since 2021, measured by the CPI. Source: FXStreet.

With price increases in the US more controlled, the Fed’s worries about inflation are fading. By itself, this reason would already be enough to reduce interest rates.

However, lately, some concerns have emerged regarding the other mandate of the Fed: to promote maximum employment.

The US labor market has been red-hot since the reopening from the pandemic, with employers consistently hiring new workers to meet strong demand for goods and services. The US unemployment rate – which measures the number of unemployed people as a percentage of the overall labor force – fell to 3.4% in January 2023, the lowest level in more than five decades.

But labor market conditions are slightly different now. The US economy continues to add jobs every month, but at a slower pace than what it used to be. The unemployment rate stands at 4.2%, which is still low by historical standards but has increased significantly in the last few months.

Jerome Powell, the Fed’s Chairman, said in this matter that “we [the Fed] will do everything we can to support a strong labor market.” In other words, Powell made it clear that the Fed would cut interest rates if needed to keep hiring levels elevated.

By how much the Fed is expected to cut rates?

It isn’t clear – and this is one of the main question marks of the upcoming Fed meeting.

Interest rates in the US are currently in a target range extending between 5.25% and 5.5%. Economists, investors, and analysts are constantly trying to predict how this level will change in the near future because this is key to determining the economy’s fortunes and thus the valuation of currencies, stocks, commodities, or cryptocurrencies.

Markets are currently betting on two scenarios for Wednesday’s meeting. In the first and more likely scenario – according to investors –, the Fed will cut interest rates by half a percentage point to a range extending between 4.75% to 5%.

The other option is that the Fed opts for a smaller reduction, lowering rates by a quarter-percentage point to 5%-5.25%.

Market pricing of Fed target rate probabilities for September. Source: CME Group FedWatch Tool.

In normal cycles, the Fed tends to change rates by a quarter-percentage point. Still, larger moves are possible in case the central bank thinks it needs to move more quickly. For example, during the onset of the coronavirus pandemic, the Fed cut interest rates by a whole percentage point in less than a month to support the economy.

Similarly, the Fed raised rates very aggressively several times in the past few years in an effort to quell inflation.

The uncertainty about the size of the cut makes this meeting particularly interesting for investors.

“The Fed likes to convey its moves in advance, and this time is different,” says Yohay Elam, Premium Product Manager at FXStreet. “With roughly a 50-50 chance of either a standard 25 bps cut or a large 50 bps reduction, the decision is the No.1 market mover. Basically, stocks and Gold will jump up on a 50 bps cut, while the US Dollar would benefit from a 25 bps slash,” he said.

Will the Fed continue to cut rates, or is this a one-time thing?

Fed officials repeatedly say that the central bank is “data-dependent”, meaning that any action in the future will depend on data collected about the state of the US economy.

Usually, the Fed keeps an eye on data related to both inflation and the labor market. However, in the current context, the latter is gaining more importance because price growth seems already under control and, as explained, there are increasing signs that labor market conditions could be deteriorating.

Investors are expecting the Fed to further cut interest rates in the two scheduled meetings that the central bank will hold before the year ends (apart from the one on Wednesday).

Fed officials haven’t confirmed any of this, but Wednesday’s meeting will also offer a sneak peek at what’s to come. Each of the members of the Fed will provide their estimates of where they think interest rates are heading, and this will give key insights about the chances of more cuts going forward.