The calibration of interest rates can be seen as a tool that affects the supply and price of money in an economy. The Fed’s main policy tool, the federal funds rate, sets the price of credit globally and the price of borrowing in the economy, from home loans to business loans.
The United States’ Central Bank, the Federal Reserve, has been under intense scrutiny from the international financial community in 2025 as it navigates a more complex macroeconomic landscape. The decisions made by America’s monetary authority in the past year have had a big effect outside of the United States, affecting the liquidity conditions of global banking markets and compelling central banks from London to Tokyo to reassess their own monetary policy frameworks. The Fed’s interest rate decisions have become essential to preserving global financial stability at a time when inflationary pressures are still present, global growth is slowing, and political influence over monetary policy is being closely examined.
The calibration of interest rates can be seen as a tool that affects the supply and price of money in an economy. The Fed‘s main policy tool, the federal funds rate, sets the price of credit globally and the price of borrowing in the economy, from home loans to business loans. At the start of 2025, the Fed’s Federal Open Market Committee began the reversal of a prolonged period of monetary policy tightening by lowering the target range of the federal funds rate. The Fed’s growing optimism about the inflation target being close to its 2% target and the need for a dovish policy to stimulate economic growth was evident in the steady lowering of the policy rates in late 2024 and early 2025.
These changes have been occurring against the background of growing pressures in financial markets for a “reset” in monetary conditions, while at the same time, policymakers have been emphasising a “cautious” approach. While some investors had been looking forward to a transition that would be quick to cuts, the Fed communication has remained nuanced, suggesting a gradual approach to easing policy. As a result, markets have come to understand that each change in the policy rate is more than a discrete event, but also a signal of trends in global liquidity dynamics.
The effect of the Fed’s policies on interest rates is quite important because of the central role that dollar-denominated assets have in the global financial system. The US dollar remains the dominant global reserve currency, and US Treasury securities are perceived to be the most liquid and risk-free assets that exist. This is what maintains the central role that the dollar has in global finance, and thus, the effect of US monetary policy is quickly transmitted into the global credit system.
When the Fed reduces interest rates, the money flows out of dollar instruments and into higher-yielding instruments in other countries. When the cost of borrowing in the US is high, or when it remains high, the money flows back to America’s highly liquid markets, thus reducing global liquidity outside the US.
In the second half of 2025, the Fed’s cuts in interest rates caused changes in the global capital flow pattern, which became apparent at once. The initial cut in interest rates brought about changes in the yield differential, which caused the dollar to weaken, and this led to a rotation of capital into emerging markets and other risk assets as investors looked for higher returns in a lower-rate environment. This ‘great rotation’ is how some analysts have termed this phenomenon.
However, the correlation between US interest rates and international liquidity is much more complex than the straightforward cause-and-effect relationship suggested by capital rotation. Liquidity in banking systems – the key to life that ensures banks can meet their short-term commitments and extend credit – is affected by central bank balance sheets and interest rates. In recent years, the Fed has reversed some of the extraordinary steps taken in the past to address crises such as the Global Financial Crisis and the pandemic.
This tightening of the monetary base is achieved through a reduction in the reserves that the banks hold at the central bank. Although the rate at which the balance sheet has been shrinking has eased to avoid putting too much pressure on money markets, the trend has been towards a leaner balance sheet for the central bank compared to the peak during the pandemic.
However, for policymakers and financial institutions, the process of managing these variables is not very easy. This is especially true in the context of the global financial system which is characterised by different policies on monetary issues. While the Fed has been alternating between data-driven tightening and prudent easing, the other major central banks have been pursuing different policies. The European Central Bank, for instance, has been improving its infrastructure to facilitate euro liquidity in the global markets, thus recognising the fact that global liquidity is not driven by the efforts of one institution but by the combined effect of many.
Such diverse policy actions highlight the interconnectedness of the global banking system. A rate decision in Washington can affect the levels of liquidity from Frankfurt to Singapore. With the Fed’s decision on the interest rate, exchange rates, global credit patterns, and even the policy agendas of other central banks are affected. In fact, central banks such as the Bank of England and the ECB usually make adjustments in their own policy announcements in light of the global financial environment shaped by the Fed’s decisions.
However, the relevance of US monetary policy goes beyond the liquidity effects. The political setting in which the independence of the Fed is being debated has become a topic of prime concern in the early months of 2026, as European policymakers have voiced their worries about the possible political influence on the Fed and its effects on global inflation. The Bundesbank, for example, has pointed out the danger of political interference in monetary policy, which could damage its credibility and contribute to inflationary pressures not only in the US but worldwide.
This brings to light an important aspect of international financial stability: in an integrated monetary system, the credibility and consistency of policy implementation are as important as the mechanics of policy implementation. Central banks must be able to communicate effectively and maintain their independence in order to ensure market and banking institution confidence. In this context, the 2025 interest rate reset has brought to light the power and weakness of monetary policy in the modern world.
