Federal Reserve rate cuts' domino effects on global economy and financial markets

Editor's note:  Liu Chunsheng is an associate professor at the Beijing-based Central University of Finance and Economics. The article reflects the author's opinions and not necessarily the views of CGTN. It has been translated from Chinese and edited for brevity and clarity.

The U.S. Federal Reserve announced, following a two-day monetary policy meeting, that it would lower the target range for the federal funds rate to 4.75 percent to five percent, a cut of 50 basis points. This marks the first interest rate cut by the Federal Reserve since 2020. It is believed that historically, the Fed rarely cuts rates by such a significant margin of 50 basis points unless there is a major economic crisis. The Fed's decision to cut rates more aggressively than expected may be aimed at achieving an economic "soft landing" and to hedge against the risk of a slowdown in economic activity. This policy change will profoundly impact various aspects, including the U.S. economy, the world economy and the global market.

Following the Federal Reserve's policy meeting on September 17-18, the market widely expected the Federal Open Market Committee to lower interest rates by cutting the current peak rate by 25 basis points. This rate adjustment would mark a significant shift in the Fed's monetary policy. Even before the rate cuts took place, its anticipation had already caused considerable market fluctuations, as evidenced by the sharp rise in bond prices.

Direct impact of Fed's rate cuts

The most direct impact of the Fed's rate cuts is the reduction of borrowing costs, which stimulates consumption and investment in the U.S. Lower interest rates mean reduced financing costs for businesses and individuals, promoting economic activity and boosting market confidence. For businesses, lower interest rates make financing cheaper and more convenient, encouraging expansion of production, boosting investment in new projects, or mergers and acquisitions. For consumers, reduced interest expenses on mortgages, car loans and credit cards will increase disposable income, thereby driving consumer spending.

However, rate cuts could also lead to increased inflationary pressures. Although the current inflation level may be within a reasonable range, rate cuts could also lead to economic overheating and price increases. Therefore, the Fed needs to carefully balance inflation and economic growth during the rate-cut process to avoid excessive monetary accommodation and threats to price stability.

Global spillover effects

The Fed's rate cuts often have global spillover effects. As one of the most important central banks in the world, the Fed's monetary policy adjustments have profound impacts on the decision-making of other central banks and market behaviors.

Firstly, rate cuts might lead to capital flowing from the U.S. to higher-yielding emerging market countries, stimulating their stock and bond markets. However, this could also bring new financial risks, especially if the economic fundamentals of these countries are fragile.

Secondly, the Fed's rate cuts usually trigger similar actions by other major central banks, creating a trend of global monetary easing. Especially in the current context of global economic slowdown, other central banks might use rate cuts to address domestic economic challenges, stabilize financial markets, and support economic growth. For example, the European Central Bank and the Bank of England might ease their monetary policies to address sluggish economic growth.

Fed actions on Chinese economy

The impact of the Fed's rate cuts on the Chinese economy is particularly complex. The rate cuts help alleviate capital outflow pressures. As the interest rate differential between China and the U.S. narrows, the motivation for funds to flow to the U.S. weakens, which is expected to stabilize the Chinese yuan and reduce the intervention pressure on the People's Bank of China (PBOC). A stable exchange rate also helps boost confidence in the Chinese economy and attract more foreign investment.

Additionally, the Fed's rate cuts might prompt the PBOC to moderately ease monetary policy to address economic slowdown and high financing costs. While the PBOC's monetary policy primarily depends on domestic economic conditions, amid a globally loose monetary environment, moderately lowering interest rates might be necessary to support stable economic growth.

Rate cuts on currencies & gold

The Fed's rate cuts primarily impact the U.S. dollar through depreciation expectations. Lower interest rates reduce the yield on dollar-denominated assets, prompting capital to shift to higher-yielding assets, which weakens the dollar. A depreciating dollar not only affects the international trade landscape but also has broad impacts on global financial markets. For example, a weaker dollar could drive up the prices of commodities like oil and gold since these are priced in dollars.

Consequently, the depreciation of the dollar puts upward pressure on the yuan. As the interest rate differential between China and the U.S. narrows, the motivation for capital outflows diminishes, potentially strengthening the yuan against the dollar. A stronger yuan is detrimental to Chinese exporters by potentially reducing export competitiveness, but the stimulation of the Fed's rate cuts to the U.S. and world economy may boost the external demand for Chinese products.

The Fed's rate cuts are usually considered favorable for gold prices. First, rate cuts weaken the dollar, which in turn raise gold prices denominated in dollars. Secondly, in a low-interest-rate environment, real interest rates fall or become negative, reducing the opportunity cost of holding non-yielding gold and attracting investors to increase their gold holdings for value preservation and hedging purposes.

Domino effects of Fed's rate cuts

In the modern economy where the global economy and financial systems are increasingly interconnected, the Fed's monetary policy adjustments undoubtedly act like a "butterfly" that not only stirs economic winds in the U.S. but also triggers chain reactions in the global markets. While the actual effects of this rate-cut decision remain to be observed and evaluated, it is undoubtedly critical for policymakers and investors worldwide to maintain high vigilance and respond actively.