How Fed rate cuts affect Dar’s economic landscape

THE most significant event in the week ending September 20, 2024, was the US Federal Reserve’s 50 basis points (bps) interest rate cut—the first since the peak of the COVID-19 pandemic in March 2020.

This move was notable for two reasons: first, markets had been anticipating rate cuts and an expansionary policy from the Federal Reserve since early 2024 and second was the size of the cut, which exceeded market expectations.

Although a rate cut was anticipated throughout 2024, US inflation and unemployment data earlier in the year had delayed the Federal Reserve’s action.

It wasn’t until August, when unemployment numbers worsened, raising fears of a recession, that the Fed acted.

While markets had expected a 25bps cut, the Federal Reserve surprised with a 50bps reduction, bringing the Federal Funds Rate to a range of 4.75 per cent to 5.00 per cent.

Before considering the potential global and Tanzanian impacts of this decision, it is essential to understand the Federal Funds Rate.

The Federal Funds Rate is the interest rate at which banks and other financial institutions lend reserve balances to each other overnight.

It serves as a critical tool for the Federal Reserve (the central bank of the US) in implementing monetary policy and managing economic conditions.

Banks are required to hold reserves at the Federal Reserve to meet regulatory requirements and ensure liquidity.

When some banks have surplus reserves and others are short, they borrow and lend through the federal funds market, where the Federal Funds Rate dictates the cost of these short-term loans.

The Federal Reserve does not set a fixed rate but rather establishes a target range for the Federal Funds Rate.

It influences this rate through tools like open market operations—buying and selling government securities—to adjust the supply of reserves in the banking system.

This enables the Fed to guide the rate within its target range depending on its economic objectives.

Changes in the Federal Funds Rate ripple across the economy, influencing other short-term and long-term interest rates, such as mortgage rates, credit card rates, and business loan rates.

In this manner, the Federal Funds Rate directly impacts borrowing costs for consumers and businesses.

By raising the rate, the Federal Reserve makes borrowing more expensive, which slows down spending and investment, helping to reduce inflationary pressures.

On the other hand, lowering the rate makes borrowing cheaper, stimulating economic activity by encouraging spending and investment.

The Federal Reserve uses the Federal Funds Rate to achieve its dual mandate of promoting maximum employment and maintaining stable prices.

By adjusting the rate, it seeks to manage inflation, stabilise the economy, and control growth.

For example, during periods of rising inflation, the Fed may raise the rate to cool the economy, while during recessions, it may lower the rate to encourage recovery.

In Tanzania, a similar tool is the Central Bank Rate (CBR), set by the Bank of Tanzania, which currently stands at 6.00 per cent with a deviation threshold of 200 bps.

The CBR is the benchmark rate for the 7-day interbank money market.

If rates deviate by more than 200 bps from the CBR, the Bank of Tanzania intervenes to stabilise money supply.

In August, the 7-day interbank rate exceeded this threshold during 60 per cent of the month’s trading sessions, prompting the central bank to inject liquidity into the banking sector through reverse repos at rates up to 8.00 per cent.

Returning to US monetary policy, the recent rate cut signals the start of an expansionary policy aimed at increasing money supply to boost investment and consumption.

Given the global influence of the US dollar, the Fed’s prior contractionary policy, which began in 2022, had created foreign exchange challenges, especially in developing economies like Tanzania.

The reversal of this policy is expected to ease global foreign exchange pressures and restore foreign inflows into developing economies.

In Tanzania, the central bank has followed a less accommodative stance over the past two years to limit money supply growth amid inflationary concerns driven by foreign exchange shortages.

Increasing money supply would have heightened demand for imports, exacerbating pressure on the Tanzanian shilling and leading to its depreciation, which has already exceeded 15 per cent over the past 20 months.

As a result, the Bank of Tanzania limited money supply through higher interest rates and repo issuances, despite low inflation of 3.0 per cent which at the bottom of the target range, and tightening liquidity in the banking sector.

Relief in the foreign exchange market may allow the Bank of Tanzania to focus on injecting liquidity into the economy, supporting credit demand and stimulating investment and consumption.

With inflation low and stable, the central bank has room to pursue a more accommodative monetary policy as the country benefits from the government’s efforts to improve the business climate and promote investments.

Additionally, easing foreign exchange pressures is expected to lift equity prices by attracting foreign investors.

The US contractionary policy had triggered a foreign investors exodus from emerging and frontier markets.

In Tanzania, net foreign outflows from the Dar es Salaam Stock Exchange over the past 20 months reached 59bn/- (21.85 million US dollars), with 53 per cent of these outflows occurring in the first eight months of 2024.

Despite this, the Tanzania Share Index (TSI) appreciated by 19.4 per cent, indicating increased domestic participation.

Over time, the US rate cut is expected to impact both the capital markets and banking sector liquidity in Tanzania.

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The capital markets should benefit from increased foreign investment, boosting equity prices and turnover.

Meanwhile, the banking sector is likely to experience increased liquidity due to improved foreign exchange availability and a more accommodative monetary stance.

Additionally, lower interest rates are expected to drive up bond prices, benefiting holders of government securities.

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