The Fed’s Latest Rate Cut: What It Means for the Economy

The U.S. Federal Reserve has cut interest rates for the first time since December, lowering its benchmark rate by 25 basis points to a range of 4.00–4.25 percent. The decision, announced on Wednesday, came as a slowing labour market stalls economic growth. Markets widely expected this move, with CME FedWatch placing the probability at 96 percent.

Why the Fed Cut Rates

The cut was driven by weakening employment data. As jobs decrease, household income falls, reducing consumption. With businesses facing weaker demand, overall economic activity slows, causing growth to stall. The Fed’s rate cut aims to counter this by stimulating borrowing, investment, and consumption.

This can be illustrated using the Keynesian AD–AS diagram. Lower interest rates shift the aggregate demand curve outward (AD₁ → AD₂). As a result, real GDP rises from Y₁ to Y₂, supporting growth. At the same time, the price level increases from P₁ to P₂, showing how rate cuts can also create demand-pull inflation if the economy is close to its bottleneck capacity.

The impact on trade is more complex. Lower rates can increase import demand since imports are an endogenous component of aggregate demand. This may worsen the balance of trade. However, lower rates also make U.S. assets less attractive to foreign investors, reducing demand for the dollar. A weaker dollar makes imports more expensive, which could reduce their volume. The ultimate effect on imports is uncertain, depending on which force dominates.

Contradictions and Inflation Pressures

This decision comes against a backdrop of mixed signals. The Fed noted in its release that “job gains have slowed, and the unemployment rate has edged up but remains low. Inflation has moved up and remains somewhat elevated.” Yet the logic is not straightforward. While rate cuts increase investment and consumption — boosting AD — they can also aggravate inflationary pressures by pushing prices higher (demand-pull inflation). At the same time, given the unemployment concerns raised in the report, the inflation currently observed is more consistent with cost-push inflation, which can be shown as a leftward shift of AS (AS₁ → AS₂). This highlights the conflicting pressures facing policymakers.

The Role of Animal Spirits

Powell emphasised that “uncertainty about the economic outlook remains elevated.” From the perspective of Keynes’s concept of animal spirits, high uncertainty reduces confidence, leading firms to delay investment and households to cut consumption. In terms of AD–AS analysis, this would shift AD leftward, lowering GDP and easing inflationary pressures. Thus, while the Fed cut rates to stimulate growth, the policy may have limited effect if businesses and consumers remain cautious.

Tariffs, Immigration, and Labour Market Shifts

In his press conference, Powell also noted the “unusual” decline in both the supply and demand of labour, pointing to tariffs and immigration restrictions as key drivers. Tariffs raise input costs, lowering firms’ profits and discouraging hiring. They also reduce exports, as retaliation makes U.S. goods less competitive abroad, further decreasing labour demand. On the supply side, immigration restrictions shrink the pool of available workers, particularly in industries like agriculture and construction. These forces cannot be addressed by monetary policy alone — while rate cuts can stimulate AD, they cannot fix structural supply-side problems that shift the AS curve.

Risks Ahead

The Fed has left the door open to further cuts, stating it would adjust rates “as appropriate if risks emerge” that threaten its dual mandate of stable prices and maximum employment. Yet repeated cuts carry risks of their own. As I interpret it, too many cuts may create more uncertainty by signalling that the economy is in worse shape than expected. This can weaken animal spirits, undermining confidence and discouraging investment and spending, which may slow growth rather than accelerate it.

Conclusion

The Fed’s latest move highlights the complexity of managing an economy under pressure from both demand and supply-side shocks. Interest rate cuts can shift AD to the right, increasing GDP and potentially raising inflation. But with cost-push pressures from tariffs and falling confidence weighing on the economy, the effectiveness of monetary policy may be limited. The balance between growth, inflation, and confidence will define how far this rate-cutting cycle goes — and how successful it will be.