The US Federal Reserve has cut interest rates overnight in an important move for the global economy.

As lots of traders expected, the Fed cut interest rates by half a percentage point, saying it was confident inflation would continue to recede.

What will it mean for Australia? 

Does it mean the Reserve Bank will have to cut rates too? What will it do to the value of Australia’s dollar? 

Why is the US cutting rates?

The US decision to cut rates means it is joining the European Union, the United Kingdom, Canada, New Zealand, Denmark, Switzerland, China, and many other countries in doing so.

The Fed has had its policy rate in the target range of 5.25 to 5.5 per cent for over a year, so its cut pushes the range down to 4.75 to 5 per cent.

See the image below, from the Federal Reserve’s website, to get a sense of what it will look like.

The Fed began lifting rates at the start of 2022, in response to inflation rising quickly in 2021.

US inflation peaked at 9.1 per cent in June 2022, and it has since fallen back to 2.5 per cent. 

The Fed’s target for inflation is 2 per cent.

The US unemployment rate has also been rising this year. It was 3.7 per cent in January, but last month it was 4.2 per cent.

Economists predicted the Fed would want to start cutting rates before inflation hits 2 per cent because there’s a long lag time between interest rate movements and their effect on the economy.

If the Fed left it too late to cut rates, it may have ended up causing too much damage to the US economy by pushing it into recession.

Federal Reserve chair Jerome Powell made it pretty clear last month that US rate cuts were on the horizon.

“The time has come for policy to adjust,” Mr Powell said.

What will it mean for Australia’s economy?

The cut will have implications for Australia’s economy.

It means the Reserve Bank’s cash rate target, which sits at 4.35 per cent, will be relatively stronger compared to US interest rates.

Keeping other things equal, that could see the value of the Australian dollar rise compared to the US dollar.

It would also have implications for investment and trade, and for Australians looking to travel overseas.

However, a lot will depend on how US Fed officials communicate their reasons for cutting rates.

“A 0.5 percentage point cut that scares markets about US economic prospects could increase the [value of the] US dollar because it is a safe haven currency,” said Carol Kong, a Commonwealth Bank currency strategist.

“However, a 0.5 percentage point cut that eases concerns about US economic prospects could undermine the US dollar.”

The graph below, from Reuters, shows how Australia’s dollar has performed against the US dollar in recent years.

On Wednesday afternoon it was worth US67.59 cents, having just touched a two-week high as currency traders wagered that the Fed would be cutting rates.

What will it mean for the Reserve Bank?

Australia has lagged the US with its interest rate movements in this rate cycle.

The RBA didn’t start lifting interest rates from their emergency lows until May 2022, which was a couple of months after the US Fed began lifting rates.

The RBA also didn’t lift interest rates as high as the US Fed — it only lifted the cash rate to 4.35 per cent, whereas the US Fed lifted rates to an upper range of 5.5 per cent.

In recent months, RBA governor Michele Bullock has acknowledged that Australia is lagging the US in the cycle and has repeatedly said it’s unlikely the RBA will cut rates this year.

“At the moment, interest rates in the United States are higher than us. We’ve been criticised for that, in fact,” she said in August.

“But we’ve chosen … very deliberately to try and bring inflation down while not turning the economy into a recession and spiking unemployment. That’s been our strategy,” she said.

In the June quarter, underlying inflation in Australia was 3.9 per cent, down from a peak of 6.8 per cent in the December quarter of 2022.

Australia’s unemployment rate has risen from 3.9 per cent in December last year to 4.2 per cent in July. The Bureau of Statistics will release the August unemployment rate on Thursday morning.

Last month, Ms Bullock said when US rates were eventually cut it would help to bring Australia’s exchange rate back into play in our fight against inflation.

“At the moment, with US interest rates higher than ours, that’s probably keeping our dollar a little bit lower,” she said in August.

“But if the interest rates in the US start to decline, which people are expecting, that will probably give a bit more support to our exchange rate.

“At the moment, everyone had increased their interest rates coming out of the pandemic so we didn’t really get much action from the exchange rate. But over the next while, as different countries go different ways, it is going to come back into play.”