Why is the US Cutting Interest Rates? What Could It Mean for Australia?

The global economy took a significant turn overnight as the US Federal Reserve reduced its interest rates by half a percentage point. This decision, long anticipated by many market watchers, signals confidence from the Fed that inflation is on a downward trajectory.

But what does this rate cut mean for Australia? Could it pressure the Reserve Bank of Australia (RBA) to follow suit, and how might it influence the value of the Australian dollar?

Why Did the US Cut Interest Rates?

By reducing rates, the US is joining a host of other economies – including the UK, European Union, Canada, New Zealand, Denmark, Switzerland, and China – in easing monetary policy. Prior to this cut, the US Fed’s target range had held steady between 5.25% and 5.5% for over a year. With this latest adjustment, the range has now dropped to 4.75% to 5%.

It’s important to recall that the US Fed began hiking rates in early 2022 to combat rapidly rising inflation, which peaked at 9.1% in mid-2022. Since then, inflation has fallen to 2.5%, which is closer to the Fed’s 2% target.

However, the US labour market has also been under pressure. Unemployment has crept up from 3.7% in January to 4.2% last month, adding weight to the argument that it was time for the Fed to cut rates. Economists had anticipated this move, noting the lag time between monetary policy changes and their effects on the broader economy. By acting now, the Fed hopes to avoid triggering a recession by tightening too aggressively for too long.

Federal Reserve Chair Jerome Powell hinted at this policy shift last month, stating, “The time has come for policy to adjust.”

Implications for Australia’s Economy

The Fed’s decision will inevitably have ripple effects across the Australian economy. With the RBA’s current cash rate target set at 4.35%, Australia’s interest rates are now higher in relative terms compared to the US.

One potential outcome of this disparity could be an increase in the value of the Australian dollar. Generally speaking, higher interest rates in one country compared to another can attract capital inflows, strengthening the currency. For Australians planning to travel overseas or businesses engaged in international trade, this could mean a stronger Australian dollar against the US dollar.

However, much will depend on how US officials frame the reasons behind their rate cut. As Commonwealth Bank currency strategist Carol Kong explains, if markets interpret the move as a sign that the US economy is in trouble, the US dollar could actually rise due to its status as a “safe haven” currency. On the other hand, if traders view the cut as a positive step toward sustained economic recovery, it could weaken the US dollar and boost the Aussie dollar in the process.

What Does This Mean for the RBA?

Australia has lagged behind the US in this monetary policy cycle. While the US began raising rates earlier and more aggressively, the RBA didn’t start tightening until May 2022 and stopped short of the US Fed’s peak rate, capping its cash rate at 4.35%.

RBA Governor Michele Bullock has acknowledged Australia’s slower pace and has repeatedly said that the RBA is unlikely to cut rates this year. In an interview in August, she explained the RBA’s cautious approach, saying, “We’ve chosen very deliberately to bring inflation down while not pushing the economy into a recession and spiking unemployment.”

At the same time, Australia’s inflationary pressures have eased. In the June quarter, core inflation fell to 3.9%, down from its peak of 6.8% in late 2022. Meanwhile, the unemployment rate has edged up slightly from 3.9% in December 2022 to 4.2% in July 2024.

But the US rate cuts may have some positive side effects for Australia. As Bullock pointed out, the high level of US rates has been keeping the Australian dollar relatively weak, which has helped cushion some of the blow from inflation by making imported goods more expensive. If US rates continue to fall, we could see some upward pressure on the Australian dollar, giving the RBA more flexibility in its inflation fight.

Could Australia Be Forced to Cut Rates?

With central banks in major economies like the US, Europe, and Canada cutting rates, there will be growing pressure on the RBA to follow suit. While Bullock has remained steadfast in her commitment to keeping rates steady for the near future, the global economic environment could create conditions that compel the RBA to act sooner than anticipated.

The RBA’s next move will depend on several factors, including the continued trajectory of inflation, employment data, and global monetary policy trends. A stronger Australian dollar could help ease inflationary pressures, potentially reducing the need for further rate hikes.

However, if the global economy shows signs of slowing or if markets begin to panic about the health of the US economy, the RBA could be pushed into a position where rate cuts are necessary to protect Australia’s own economic outlook.

In any case, Australians should keep a close eye on the actions of the US Federal Reserve and other major central banks. The decisions made in Washington, Brussels, and elsewhere will undoubtedly have far-reaching implications for Australia’s economy, trade, and investment landscape in the months to come.