The Federal Reserve’s interest rate decisions remain a focal point for markets. While the timing
and size of rate cuts are the subject of debate, why the central bank is cutting rates and how the
full rate cut cycle might play out are far more important. This is because the implications are not
as straightforward as they might seem, and market expectations have shifted dramatically over
the past year. What should investors know about how rate cuts have historically impacted the
economy and markets?
The rationale behind Fed rate cuts is important
The Fed typically lowers interest rates in
response to a weakening economy, since
doing so makes it cheaper for individuals
and companies to borrow, while also
increasing the incentive to spend rather
than save. In theory, this boosts growth
and supports the financial system,
especially during recessions and financial
crises. Over the past few decades, the Fed
made dramatic rate cuts during the early
2000s dotcom bust, the 2008 global
financial crisis, and the pandemic in 2020.
How the economy and markets typically
behave during rate cut cycles can be easily
misunderstood from these historical
episodes.
While lowering rates is intended
to promote growth, doing so during an economic crash means that a recession and bear market
are likely to follow and last several quarters after the first cut. This means that rate cuts are
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historically correlated with poor market returns even though it’s clear that rate cuts were in
response to, rather than the cause of, these challenges.
Conversely, while rate hikes are typically seen as slowing the economy, they often occur during
economic booms and bull markets as the Fed slowly pumps the brakes. Thus, counterintuitively,
rate hikes have historically corresponded to strong returns.
Today, the Fed is not battling a sudden economic collapse or financial crisis, but is instead
navigating a period of steady but slowing growth with improving inflation and a weakening but still
strong labor market. In other words, the current situation is quite different from periods of
emergency rate cuts. This is why the rationale for lowering rates matters when considering how
they might impact markets in the months and years ahead.
Perhaps a more applicable example is the 1994-1996 rate cycle, when the Fed raised rates to
combat inflation fears before lowering them again shortly thereafter. Periods like these are often
referred to as “soft landings” since the Fed arguably managed to cool the economy without
triggering a recession. While there was a significant shock to the bond market – just as there was
in 2022 – markets eventually responded positively to rate cuts once the economy stabilized.
The Fed’s task is to balance inflation and growth
The Fed’s dual mandate, as described in
the 1977 Federal Reserve Act, is “to
promote maximum employment and stable
prices.” Today, this is interpreted as
returning inflation to 2% while ensuring the
economy continues to grow steadily.
These objectives can be in conflict, since
faster growth should, in theory, result in
higher inflation. From 2009 to early 2020,
inflation was nearly non-existent, allowing
the Fed to keep interest rates exceptionally
low resulting in one of the strongest job
markets in history. In contrast, the inflation
of the past few years has required the Fed
to make tough choices between price
stability and jobs.
Fortunately, inflation has been improving since its peak in 2022. The latest Consumer Price Index
report showed that prices continued their gradual descent in August, with the headline index rising
only 2.5% year-over-year. However, the Fed is hesitant to declare victory since core CPI, which
excludes volatile food and energy prices to measure the underlying trend, experienced a slight
uptick to 3.2%. This was primarily due to stickiness in housing prices which has been a point of
concern for economists.
It’s been said that monetary policy works with “long and variable lags.” In other words, if the Fed
waits for inflation to be all the way back down to 2%, it may have waited too long. The cost of
doing so would be an over-tightening of the job market, which would have real world consequences
on households and businesses. Thus, the recent softening in the employment data provides further
support for reducing rates.
Bond yields are adjusting to rate cuts
Given these economic trends, most
economists and investors believe the Fed
will cut rates a few times this year and
throughout 2025. Bond yields have
responded with the yield curve
“disinverting” for the first time since the
rate hike cycle began in 2022. This is
because short-term interest rates, which
are tied to Fed policy, have begun to fall
while long-term interest rates, which are
tied to economic growth, have not declined
as much. This results in an “upwardsloping”
yield curve which is often seen as
positive for the economy.
While the past is no guarantee of the future, lower rates have
been positive for
both stocks and bonds across history. Bond prices, in particular, move in the opposite direction of
bond yields, which is why many bond indices have rebounded in recent weeks.
For stocks, lower interest rates mean that businesses have access to cheaper financing for
investment and expansion. When it comes to the math of valuing companies, lower rates mean
that future cash flows are discounted less, which can result in more attractive prices today. Of
course, the market never moves up in a straight line, and investors should always be prepared for
periods of volatility as the financial system adjusts to Fed moves.
As we enter a new phase of monetary policy, economists will be closely monitoring these
indicators, particularly those related to employment and growth. The Fed’s challenge will be to
calibrate its policy response to support the economy without reigniting inflationary pressures or
creating imbalances in financial markets.
The bottom line? Understanding why the Fed is cutting rates is as important as the
policy moves themselves. Rather than focus on individual rate cuts, investors should
maintain a long-term perspective to stay on track toward their financial goals.
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