The Federal Reserve's Rate Cuts

How It Could Affect the Economy

The Federal Reserve is set to cut interest rates on Wednesday, a move that will gradually ripple through the economy over time. While the immediate effects seem straightforward — borrowers will pay less on their debts, and savers will receive lower returns on their cash — the broader implications of these rate cuts remain uncertain. Every rate-cutting cycle is unique, and the economy's response is often both prolonged and unpredictable.

• Historically, the Fed cuts rates when the economy is in significant distress. However, this time is different.
• While the labor market has cooled, it remains robust, and the broader economy is experiencing solid growth.
• In fact, the current economic conditions are better than in 1995, a rare instance when the Fed successfully achieved a "soft landing" — reducing inflation without triggering a spike in unemployment.
• Since the economy is not on the brink of recession, the effects of lower interest rates could materialize more quickly. For instance, if consumers are not worried about imminent job losses, reduced rates might encourage spending.

However, the elevated valuations of stocks and other assets could limit their ability to provide a substantial boost.

What to Expect

The Federal Reserve's influence over interest rates is not absolute. It primarily controls short-term rates, like the ones banks charge each other for overnight loans. When these rates fall, banks generally lower the prime rate, which affects credit cards and other loans. Long-term rates, which impact mortgages, also tend to decline.

• The Fed has raised rates 11 times since early 2022 to curb inflation, moving its target from near zero to about 5.4%.
• Analysts expect a modest reduction of 0.25 or 0.5 percentage points this week, but more cuts may follow throughout the year.
• Even with this week’s cut, interest rates will likely remain at levels that restrict economic activity.
• Models from the Atlanta Fed suggest that the "neutral" rate — the rate that neither stimulates nor slows the economy — currently ranges from 3.5% to 4.8%.
• Therefore, it will take several rate cuts before consumers and businesses feel a substantial impact.
• Credit card rates, which are closely tied to the Fed's target rate, could decline slightly, benefiting those with variable-rate loans, such as small businesses.
• Futures markets indicate that investors anticipate a total rate reduction of 1.25 percentage points by the end of this year and another 1.25 points by 2025.

While the Fed sets short-term rates, long-term rates are driven by investor expectations about future Fed actions. This dynamic is evident in the yield on the 10-year Treasury, which has fallen to 3.65%, down from 5% last October. This decline in long-term rates has brought down the average 30-year mortgage rate to 6.2% from 7.22% in early May.

Key Beneficiaries

Lower interest rates often help the economy by stimulating the housing market. Mortgage applications for buying homes have recently ticked higher, although they remain below levels seen when rates first fell below 7% last year. Analysts believe that rates dropping below 6% or even 5.5% could trigger another surge in housing demand.

• Rates for home-equity lines of credit (HELOCs), which are tied to short-term rates, may also decline. Given the significant rise in home prices, many homeowners have accumulated substantial equity.
• Lower rates could encourage businesses to invest in equipment, from tractors to computers. Although borrowing costs for large companies have already decreased, rates for small businesses are still relatively high but should drop further as the Fed cuts rates.
• Typically, it takes time for lower rates to translate into faster investment growth. However, business spending on equipment has been weak, increasing just 5.3% since 2019, compared to 9.4% for overall GDP.

As equipment wears out, businesses may need to invest more to maintain operations, potentially accelerating spending in response to rate cuts.

Other Indirect Effects

Rate cuts can also impact the economy indirectly, such as through the currency market. Lower U.S. interest rates relative to other countries tend to weaken the dollar, making American products more competitive abroad.

• However, this effect could be muted if other central banks, like the European Central Bank, also cut rates.
• Another common consequence of rate cuts is higher asset prices, which can make financing easier for companies and increase consumer spending due to a perceived wealth effect.

Additionally, the mere fact that rates are being cut may boost confidence among businesses and households, reducing fears of a recession.

Disclaimer

Please note that Benchmark does not produce investment advice in any form. Our articles are not research reports and are not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.

Credits

Photo by Julien Riedel / Unsplash.