by Kari Grenade, PhD, Caribbean Economist and Macroeconomic Advisor
On 19 September 2024, the Central Bank of the United States, the Federal Reserve, commonly referred to as the FED, lowered its benchmark interest rate (the rate that guides overnight lending among US banks) by 0.5 percentage points to 4.75% to 5.0%.
The FED’s benchmark rate had been on the rise in the past 2 years to tamp down inflation in the US, which reached record highs amidst acute global supply chain issues, primarily, but not exclusively because of the Russia–Ukraine war. The rate cut on September 19 was the first since March 2020, signalling a turning point in the FED’s fight against inflation. Inflation in the US has indeed slowed; the annualised rate decelerated for a fifth straight month to 2.5% in August 2024, the lowest inflation rate since February 2021. With inflation subdued in the US, more rate cuts are likely in this year and in 2025.
The September rate cut is a big deal for the US against the backdrop of 11 rate hikes during the period March 2022 to July 2023 (the rate was held steady until the cut). The decline in the rate sets the stage for lower borrowing costs for US consumers and businesses, which will impact their consumption and investment decisions — acquisition of credit cards and borrowing for consumer items and business expansion will become more affordable. Moreover, the reduction in the FED rate will cause rates on US investment securities to fall also, making them less attractive to investors, resulting in a lower demand for US dollars, weakening its value. A depreciation of the US currency against major global currencies will benefit US exports (the US will be exporting goods that are now cheaper relative to other major advanced economies and as such, more US goods will be purchased abroad). On balance, the US economy overall stands to be positively impacted by lower inflation and higher exports, consumption, and economic activity. Risks, including excessive lending and borrowing that are typically associated with falling interest rates, will have to be mitigated through appropriate policies.
Not only is the FED’s rate cut a big deal for the US, but it is also a big deal for the Caribbean given the inextricable link between the US economy and Caribbean economies. Key transmission channels to the Caribbean of the reduction in the FED’s rate will be through tourism, investment flows, debt servicing, and credit.
Regarding tourism, US tourists may have more disposable income and may be more inclined to travel to the Caribbean, while non-US tourists will find it less expensive to travel to the Caribbean with a weaker US dollar against their home currencies. For tourism-dependent Caricom countries whose currencies are fixed against the US dollar (The Bahamas, Barbados, Belize, and the countries of the Eastern Caribbean Currency Union), a depreciation of the US dollar against the pound sterling or Canadian dollar for example automatically means a depreciation of the Barbadian dollar and the EC dollar for example, against those currencies as well. Because hotel rooms, tours, arts, and crafts are all priced in US dollars, a “stronger” pound sterling or Canadian dollar for example (against the US dollar) would be able to “stretch further” in Barbados or St Lucia for example.
Regarding investment flows to the Caribbean, on the one hand, sectors such as real estate, tourism, renewable energy, and construction may attract increased foreign investments as the cost of capital declines. However, on the other hand, interest rates earned on investment instruments in the US will fall, negatively affecting interest income for firms and institutions with holdings of US fixed-income financial investments.
On debt servicing, Caricom countries with a sizeable portion of US dollar-denominated debt instruments of variable interest rates will benefit from lower debt servicing costs, which may provide extra fiscal space in national budgets to be channelled towards more strategic development priorities.
Should interest rates continue to fall in the US, eventually Caribbean financial institutions will have to lower interest rates they pay on deposits and charge on loans. Savers’ passive income will decline from lower earned interest, but borrowers will benefit from reduced lending rates.
Overall, falling interest rates should be a net positive for Caribbean economies on balance, especially if risks that are typically associated with falling interest rates, such as excessive credit creation and borrowing are mitigated through appropriate macroeconomic policies. In particular, financial institutions will need to ratchet up risk management to preserve financial stability.
