US Federal Reserve ends four-year rate hold with jumbo half-point cut

On September 18, the US Federal Reserve – the American counterpart to the Bank of Canada – cut its benchmark Federal Funds Rate (FFR) for the first time in four years, decreasing it by half a percentage point to a range of 4.75 - 5%.

The accompanying “dot plot” – the forecast published by the central bank – also indicates the rate will decrease by another 50 basis points by the end of the year, a full 1% in 2025, and another 50 basis points in 2026. Should all those cuts materialize, the FFR would work out to 2.875%.

The Fed had kept the FFR unchanged – and at a 23-year high – ever since July 2023, following a series of rapid rate hikes that kicked off in March 2022, at the end of the pandemic lockdowns. The purpose of these increases was to quell inflation growth, which had hit a 40-year high of 9.1% in July 2022.

It’s a similar path as to the one followed by the Bank of Canada – but the key difference is that inflation has been more challenging to cool south of the border. While the BoC started cutting its own benchmark borrowing rate back in June (and has since lowered the rate by a cumulative 75 basis points), the Fed has been holding out to see inflation fall further.

The needle on American inflation finally started to move in July, when the monthly reading fell to 3%, followed by a drop to 2.9% in August. 

However, it was a softer-than-expected US labour market report out on August 2 that stoked expectations a rate cut was coming; the report showed the American economy had added far fewer jobs than expected, with the unemployment rate rising to 4.3%. That kicked off fears that interest rates had remained too restrictive for too long, and had risked destabilizing the economy.

Those softer jobs numbers, along with other signs the American economy is weakening, gave the Federal Open Funds Committee the rationale to put forth a half-point cut, rather than limit its first decrease to just a quarter of a per cent.

“The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run,” states the release that accompanied the Fed’s decision.

“The Committee has gained greater confidence that inflation is moving sustainably toward 2 percent, and judges that the risks to achieving its employment and inflation goals are roughly in balance. The economic outlook is uncertain, and the Committee is attentive to the risks to both sides of its dual mandate.”

“The cuts will keep on coming”

Given how closely the Canadian and American economies work together, the factors that impact the US Fed also greatly influence the Bank of Canada – and the two central banks don’t stray far from each other on their rate direction. While the BoC’s rate cutting cycle is already underway, that the Fed cut by a half point could set the stage for a jumbo cut north of the border as well, especially as our Canada’s most recent August inflation reading showed CPI is now just 2% – the target the central bank has been looking to achieve.

“We've already seen one weak inflation reading, with one more CPI report and GDP out before the next BoC policy announcement. If GDP comes in soft, and it looks like the output gap could widen further, the dovish members look like they'd be leaning toward a 50 bp cut,” writes Michael Gregory, Deputy Chief Economist and Managing Director of Economics at BMO.

“It's just a question of whether the weaker data and those on the GC who are more concerned about downside risks can sway the more hawkish leaning members. Either way, the cuts will keep on coming.”

How will this impact Canadian mortgage rates?

Currently, the overnight lending rate in Canada is 4.25%, with a corresponding prime rate of 6.45% at most lenders. As a result, the lowest five-year variable mortgage rate in Canada is 5.3%. Should the BoC implement a half-point cut in its next announcement on October 23, the benchmark borrowing and prime rates will fall to 3.75% and 5.95%, respectively. That will cause variable rates to drop further, though to what extent at each lender depends on the spread to prime they offer on their products.

Fixed mortgage rates have also been trending lower in recent weeks, as the bond market generally reacts favourably to anything that suggests additional rate cuts. As of publish time, the five-year government of Canada bond yield has dropped to the 2.7% range, paving the way for lenders to cut fixed rates. In fact, the lowest available five-year fixed rate in Canada is now 3.99%, the first time it has gone below the 4% threshold since June 2022. Should further downward pressure persist on yields, borrowers can expect additional discounts.

Also read:

• Canadian CPI lowers to 2% in August
• US inflation slows to 2.9% in July
• The August stock sell-off means for mortgage rates
• Bank of Canada cuts target interest rate by 0.25% in September announcement
• Federal government announces 30-year amortizations for all first-time buyers, $1.5 million cap for insured mortgages