The Fed has cut interest rates again! Understand how the Fed cut rates this time in just 3 minutes!

Hello everyone, today let's talk about the Fed's rate cut on December 19, 2024. At its December meeting, the Fed announced a 25 basis point rate cut, lowering the federal funds rate target range from 4.5%-4.75% to 4.25%-4.5%.

This marks the Fed's third consecutive rate cut this year, with cumulative cuts reaching 100 basis points. So why did the Fed cut rates? And how did it achieve this? Let's find out.

Why the rate cut?

1. Supporting employment and controlling inflation: The Fed's primary goal is to better fulfill its dual mandate of supporting employment and controlling inflation. With US inflation currently within a reasonable range, the importance of employment has increased. Rate cuts help stimulate the economy and create more jobs.

2. Stimulating economic growth: Rate cuts reduce corporate borrowing costs, encouraging companies to take on more debt, expand production and investment, raise wages, and drive economic growth.

3. Boosting consumer confidence: Rate cuts also help boost US consumer confidence, lower household financing costs, and stimulate domestic consumption and economic growth.

4. Impact on financial markets: Rate cuts facilitate capital inflows into US stock and bond markets, pushing up asset prices.

How was the rate cut achieved?

The Fed primarily achieves rate cuts by adjusting the federal funds rate target range. However, the Fed doesn't directly lower this range but implements monetary policy to reach this goal. The Fed uses both conventional and innovative policies.

Conventional measures include open market operations (OMO), adjusting discount loans, and changing reserve requirements. Innovative measures include adjusting the overnight reverse repo rate (ON RRP), interest on excess reserves (IOER), quantitative easing, lending facilities, and forward guidance.

In the December 19, 2024 rate cut, the Fed used two measures: adjusting the overnight reverse repo rate and discount loans to lower the federal funds rate. Specifically:

1. Adjusting the overnight reverse repo rate (ORR):

The US overnight reverse repo has two steps. First, the Fed sells securities to banks and other counterparties, effectively withdrawing money from the market. Then, the next day, the Fed buys back the securities from the counterparties, returning the money.

As the name suggests, the overnight reverse repo has a one-day term (overnight), and this "buy-sell" transaction involves a "repurchase" operation. Essentially, the reverse repo agreement can be seen as a "collateralized" lending activity.

Why go through this back-and-forth process?

This can be understood as the Fed's way of absorbing excess short-term liquidity in the market. When the Fed believes market liquidity is insufficient, it can reduce the scale of overnight reverse repos. With the Fed absorbing less money, more funds remain in the market, making money less "valuable" and putting downward pressure on short-term rates.

2. Discount lending rate:

This can be understood as loans provided by the Fed to depository institutions, categorized as primary credit, secondary credit, and seasonal credit. Primary credit is for financially sound institutions; secondary credit is for financially troubled institutions; and seasonal credit is for institutions with seasonal needs (e.g., those serving agriculture/tourism).

This time, the primary credit rate was lowered slightly from 4.75% to 4.50%. This means US financial institutions can now borrow from the Fed at 4.50%, reducing their reliance on other lenders charging higher rates, thereby pushing the broader market rate down to the Fed's target range.

Summary: The Fed's rate cut decision is based on analysis of current economic conditions and forecasts of future trends. By adjusting the federal funds rate target range and conducting open market operations, the Fed seeks to balance inflation control and employment support.

This decision not only affects the US economy but also has far-reaching implications for the global economy. We hope this article helps you better understand the reasons behind and mechanisms of the Fed's rate cuts. See you next time!