What Happens After Rate Cuts?
The Federal Reserve has a dual mandate of promoting maximum employment and stable prices. Their ultimate role is to set monetary policy that balances supporting a strong economy while keeping inflation under control. This monetary tightrope they are walking isn’t easy. So far, the Federal Reserve has managed a “soft landing” of reducing inflation without causing a recession, which is difficult and rare, and time will tell if they can ultimately pull it off.
We have all felt the effects of inflation that began to skyrocket in 2021. To combat this high inflation, the Federal Reserve rapidly raised rates from essentially 0% to over 5%. This had wide-ranging effects on the economy, investments, real estate, borrowers, savers, and the government. With inflation dropping closer to the Federal Reserve’s 2% target, and with employment starting to slow, the Federal Reserve cut interest rates by 0.5% to 4.75%-5%, last Wednesday, the first rate cut since the Covid pandemic. As we take a look at various impacts rate cuts can have, it’s important to keep in mind that there are many constantly changing variables and each scenario is unique.
Economy – The economy is a large and complex machine. A case can be made for how strong or weak the economy is depending on the information being evaluated and the lens used to view it. Given the recent move and comments by the Federal Reserve, they are signaling that the economy is still strong but showing some signs of weakness, specifically in the labor market, and that inflation has cooled to a point where inflationary pressure isn’t as concerning. Reducing interest rates is intended to help stimulate the economy, making it less expensive for individuals and businesses to borrow and spend.
Stocks – The picture is mixed on how rate cuts affect the stock market. In many cases the stock market initially responds positively (see the chart below from Charles Schwab which shows 12-month returns following the first rate cut have been positive 86% of the time going back to 1929), however, if the rate cuts aren’t enough to overcome economic weakness, stocks can suffer. Taking a longer-term view, the stock market has rewarded patient, long-term investors, but interest rate cuts don’t provide a clear signal of where the market is heading over the next few years.
Source: Charles Schwab, Bloomberg, and the Federal Reserve.
Data from 08/09/1929 through 07/31/2020. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Bonds – A basic function of bonds is that interest rates and bond prices move in opposite directions. Therefore, lower rates can increase the value of bonds for current bondholders. However, future return expectations can be reduced with lower rates. For instance, a year ago, 10-year Treasury Bond yields were approaching 5%, today 10-year Treasury Bond yields are under 4%, and therefore the return expectation is now lower.
Cash – Savers have benefited from higher interest rates over the last few years as many high-yield savings accounts and CDs have paid rates in the 5% range. This was refreshing after almost a decade of cash earning around 1%. With lower rates, banks will adjust what they pay savers. That said, there is hope that these changes will be gradual and won’t return to those 1% levels anytime soon. Many economists and the Federal Reserve’s current outlook indicates that rates may normalize around a neutral rate (this being the rate that isn’t intended to slow or stimulate the economy but maintain a neutral position) of 3% rather than the previous ultralow rate environment.
Borrowers – While savers have benefited from high rates, borrowers have been hurt. The cost to borrow on everything from home loans to credit cards has increased significantly. The recent interest rate cut should bring lower borrowing costs, but I would caution against any expectations of a quick return to 3% mortgage rates, as an ultralow interest rate environment doesn’t appear likely at this point.
Real Estate – The real estate market has been a conundrum ever since the Covid pandemic changed many aspects of our lives. Though the real estate market can vary widely by location, prices have remained fairly stable despite borrowing costs more than doubling from the low rates of several years ago. It would be reasonable to think that with lower rates the market could stay strong or even grow stronger, however, if the economy weakens and unemployment increases, the real estate market could suffer. Beyond borrowing costs, another major factor affecting the housing market is supply, and there is a lack of housing in our country which helps explain why homes have continued to be so expensive. This is a challenging situation and it’s no wonder it’s a hot political topic this election cycle.
Government – For years our government has been running annual budget deficits that the government finances by selling bonds such as Treasuries. As interest rates rose, the cost of servicing our government's debt grew substantially. According to the Congressional Budget Office, the government is projected to spend $892B this year in net interest, up from $658B last year (a 36% increase) and putting it above the amount spent on defense. Even with lower rates, the cost to service our debt is projected to rise as our deficits and debt grow. Of note, the Federal Reserve is a government agency that reports to Congress but technically isn’t driven by fiscal or political policy, though its actions can have direct impacts on both.
If you have questions about your finances or retirement, I’m happy to discuss them with you. You can reach me at advisor@blakegallion.com.
