US central bank takes major action, cuts interest rates for the first time since 2020

The US central bank has cut interest rates in the United States for the first time since 2020. The sharp cut, a reduction of half a percentage point to a level of between 4.75 and 5.00 percent, should keep the world’s largest economy vital now that the battle against inflation appears to have been won.

The markets had already decided that the interest rate would be cut, but expectations varied as to the size of the interest rate cut. The question was whether it would be a cautious 0.25 percentage point or a more drastic decision of 0.5 percentage points. Of the directors who voted on the decision, eleven were in favour of a reduction of half a percentage point, but one would have preferred a step back of a quarter.

Fed Chairman Jerome Powell had already indicated at the end of August that the time had come for this. Before the interest rate decision, a majority of the market had also expected a cut of half a percentage point, the first in a series of steps back now that inflation is approaching the 2 percent target. With the lower borrowing costs, the American central bank wants to support the largest economy in the world, now that the battle against inflation seems to have been won.

Inflation cooled down

Last week, it turned out that inflation in the US cooled to 2.5 percent in August, from 2.9 percent a month earlier. That is the lowest level since February 2021. However, so-called core inflation, which excludes the fluctuating prices of food and energy, remained high at 3.2 percent.

Since the inflation explosion in 2022, the Fed has raised interest rates in several steps from 0 to 5.5 percent. The last rate hike dates from July 2023, when interest rates rose to between 5.25 and 5.50 percent. That was the highest level since 2001. The US central bank kept interest rates at that high level for more than a year to ensure that inflation would move back towards the 2 percent target.

After a series of meetings this spring in which the central bank hinted at a rate cut, Powell announced in a speech in August that it was time for “a change in policy.” Its European counterpart, the European Central Bank (ECB), began its downward cycle in July, and last week announced its second downward rate cut of a quarter percent. The European rate now stands at 3.5 percent.

A first cut of a quarter of a percentage point was long considered in the US, until articles appeared in the US and British financial press last week advocating a cut of half a percentage point. This was apparently prompted by the fact that inflation at 2.5 percent is already close to the target level of 2 percent, while interest rates are showing clear signs of cooling. This means that the current interest rate is no longer appropriate for the state of the economy. The Fed is now choosing to change this as soon as possible.

Recession

Deutsche Bank pointed out on Wednesday morning that it would not be the first time that the Fed has kicked off a series of rate cuts with a half-percentage-point step. That also happened in 2001 and 2007, in both cases on the eve of a recession. Also in March 2020, after the outbreak of the coronavirus pandemic, the Fed cut by half a percentage point, followed by another full percentage point twelve days later.