Federal Reserve's Interest Rate Cut: What Does it Mean for the Economy and the Presidential Election

By Arun Dahal Khatri

On September 18th, the Federal Reserve made a critical and crucial decision to lower its standard interest rates and bringing the federal funds rate to a range of 4.75% to 5%. This is the first interest rate cut by the Federal Reserve since it had previously taken off on aggressive rate hikes between early 2022 and mid-2023 to combat rising inflation. This interest rate cut seems to begin the new practice of a new monetary easing cycle and a calculated bet that inflationary pressures are easing, allowing the Fed to refocus on supporting the labor market. Although the decision is acceptable and has an optimistic point of view, it also has implications for the economy and the political landscape, particularly with the presidential election just months away.

What made the Fed cut the interest rate just before the election? This is among the most critical and discussed questions among people. The Federal Reserve’s move to cut rates by half a percentage point is rooted in its assessment that inflation, which had been the dominant concern for much of the past year, is now largely under control. Price increases have slowed significantly, with inflation hovering at an annual rate of 2.5%, just above the Fed’s 2% target. A combination of factors, including declining oil prices and slowing rent growth, gives the Fed confidence that inflationary pressures will continue to ease. As a result, the central bank’s attention has shifted to the labor market. Although the unemployment rate is the same at 4.2%, it is still higher than it was early last year. Moreover, Most U.S. companies are delaying their hiring process because they are concerned about the labor market's weakness. By cutting rates, the Fed aims to provide a cushion for the job market, ensuring that economic conditions remain supportive for workers as inflation risks wane.

Fed Chair Jerome Powell framed the rate cut as a necessary recalibration of monetary policy to address the shifting balance between inflation and unemployment risks. The decision also serves as insurance: given the lag time between monetary policy changes and their effects on the economy, acting decisively allows the Fed to avoid potential economic downturns. Powell acknowledged that the Fed had been late in raising rates in 2022 to combat inflation, and he is determined not to repeat that mistake by acting preemptively with a more significant rate cut this time around.

Implications for the Economy

The immediate effects of the Fed’s rate cut will be felt in various sectors of the economy, particularly in borrowing costs for consumers and businesses. Lower interest rates tend to reduce the cost of borrowing, which can stimulate spending and investment. For example, mortgage rates are closely tied to the yields on government bonds, which in turn are influenced by the Fed’s monetary policy. As a result, homeowners and prospective buyers will likely see lower mortgage rates in the coming months, further fueling demand in the housing market. This came when mortgage rates had already fallen to a 19-month low, potentially boosting home sales and refinancing activity.

Similarly, businesses that rely on credit to finance operations or expand will benefit from lower borrowing costs. This could increase capital spending, hiring, and overall economic activity. However, the flip side of rate cuts is that savers may find it harder to earn meaningful returns on their deposits, as banks typically lower interest rates on savings accounts in response to Fed rate cuts. The era of high-yield savings instruments, which had been a boon for savers in recent years, may be ending. Despite the potential for increased economic activity, the Fed’s rate cut also poses certain risks. While showing some signs of weakness in the labor market, the U.S. economy has remained relatively resilient. Consumption, in particular, has been robust, and where the economy is expected to grow by 3% in the current quarter. This is well ahead of most forecasts from just a month ago, suggesting that the overall economy may not be as vulnerable as some had feared. By cutting rates aggressively in such a robust economic environment, the Fed risks sending the wrong signal to financial markets, which could interpret the move as an indication of deeper economic troubles on the horizon. Furthermore, while the Fed projects additional rate cuts in the coming year—up to another 1.5 percentage points—it is also prepared to scale back if inflation proves more persistent than expected. This circumstance is important, as the Fed is searching to balance sustainable economic growth and prevent inflation from overaccelerating.

Political Considerations

The Fed interest cut puts the flavor for the current U.S. political environment. The timing of the Fed’s rate cut, just months before the November presidential election, adds a layer of political complexity to an already charged economic debate. Historically, the Fed has been keen to maintain its independence from political pressures, and Chair Powell has repeatedly emphasized that the central bank’s decisions are driven solely by economic considerations, not political calculations. However, that has not stopped politicians from trying to influence or criticize the Fed’s actions. However, Chair Powell claimed that political ideology did not affect the decision. Former President Donald Trump, a frequent critic of Powell and the Fed during his time in office, will likely view the rate cut with suspicion. He may frame it as an attempt to bolster the economy in a way that benefits the incumbent Democratic administration, led by Vice President Kamala Harris. Trump may accuse the Fed of trying to prop up the economy to improve Harris’s reelection prospects, even though a quarter-point cut could have invited criticism from Democrats that the Fed was overly cautious in the face of economic risks. Regardless of the political noise, the Fed’s primary focus remains steering the U.S. economy toward a “soft landing,” in which inflation continues to fall and the labor market stabilizes without tipping the country into a recession. Whether the central bank will succeed in this endeavor remains to be seen, but Powell has made it clear that the Fed is committed to acting preemptively to avoid falling behind the curve again.

In the weeks leading up to the election, the Fed’s rate cut will undoubtedly be a topic of debate as both political parties seek to shape the economic narrative. Although the interest rate cut is primarily designed to demonstrate and overcome the potential financial risks, it also has some impact on political taste and could prove to be just as consequential in the final stretch of the 2024 presidential campaign.

References

https://www.economist.com/finance-and-economics/2024/09/18/why-the-federal-reserve-has-gambled-on-a-big-interest-rate-cut

https://www.federalreserve.gov/newsevents/pressreleases/monetary20240918a.htm