Fed to cut Interest rates once inflation declines: what impact on the markets?
US INFLATION AND ITS IMPACT ON THE MARKETS
Inflation represents the general level of prices for goods and services in an economy. In a growing economy, inflation tends to be higher, but so is the cost of living, since prices are rising. If an economy is in recession, more often than not inflation will be falling.
• US INFLATION AND THE FEDERAL RESERVE:
US inflation data is published on a monthly basis and is one of the major economic factors that the Federal Reserve uses to decide its policy on raising, lowering or keeping interest rates at the same level. The Fed plays a key role in managing the level of inflation and its target rate for US inflation is 2%. It and many other global banks believe this rate of inflation represents a good level for economic growth.
• INFLATION AND ITS IMPACT ON THE MARKETS
The monthly data release of Consumer Price Index figures gives traders a good opportunity to assess the state of the economy. If inflation is rising, this is traditionally associated with a rising dollar, while a lower than expected number might cause the dollar to decline in value. Each month there are also forecasted numbers from economists. The same principle applies; a higher than expected number may cause the dollar to climb and a lower number may cause the dollar to fall. One of the main reasons this relationship is thought to exist is because traders are anticipating the Fed’s next decision on interest rates. Inflation affects other instruments such as gold as well.
• THE FEDERAL RESERVE AND INTEREST RATES
The Fed meets 8 times per year to decide upon interest rates. After the meeting, the Fed Chair will give a summary. Often statements from the Fed Chair will impact the markets more than the actual decision. This is because the Chair will comment about whether inflation is under control and gives hints on future Fed interest rate decisions. The Fed has a balancing act to achieve in encouraging economic growth, but in not allowing inflation to rise too high.
• COVID PANDEMIC AFTERMATH: RECENT AND CURRENT INFLATION DATA
US inflation has climbed to its current high levels due to the aftermath of Covid. It’s been an unprecedented period, since the global economy effectively shut down during the Covid pandemic, bringing inflation down to record low levels. But when economies reopened, many people went on spending sprees armed with US government stimulus cheques, hampering global supply changes and prices rose. In June 2022 US inflation peaked at 9.1%, its highest rate since 1981. The story since is of the Fed attempting to use higher interest rates to cut inflation. Inflation remains above its target rate of 2%, and is currently 3.5%.
• FED IS THE KEYHOLDER: INFLATION OUTLOOK
The Fed increased interest rates from historic lows of 0.25% during Covid, to today’s rate of 5.5%. The Fed has signaled that it expects no more interest rate increases. The debate among traders is about when the Fed will cut rates. Inflation is the most important indicator for Fed decisions, so traders search for clues on future inflation from other economic data. For example, GDP, Producer Price Index, Personal Consumption data or Employment data provide signs on whether inflation may be rising or falling. Current expectations are that the Fed may cut rates in September. Traders had hoped that interest rates would be cut early this year.
• POTENTIAL MARKET IMPACT IF INFLATION FALLS AND RATES COME DOWN…
Expectations of rate cuts are usually associated with a falling dollar and rising gold prices and vice versa. The logic regarding gold price movements is that gold does not yield interest, so if interest rates are high this gives an incentive for investors to keep their money in cash. If rates are lower, gold becomes more attractive. But lower inflation and lower rates also tend to benefit the markets broadly. Companies may borrow money more cheaply to invest and investors may decide to trade stocks rather than place their money in banks. Commodities such as crude oil are often priced in dollars, making these commodities cheaper for foreign currency traders if the dollar’s price is falling.