The Financial Impact of Expected Interest Rate Cuts

For many months, there has been widespread expectation that interest rates will begin to drop. The Federal Reserve Board (The Fed) has been hinting at their intent to cut interest rates for some time, but as of this writing it is widely expected that a cut will finally occur after the board concludes their meeting this month. If you recall, the Fed went on an extended campaign of increasing interest rates after the COVID pandemic in an effort to reverse the rising rates of inflation. In the process, they raised the Fed Funds Rate, which is the rate banks pay to borrow money, multiple times after rates had been historically low for an extended period of time coming out of a series of shocks to the economic system. The Fed began hinting at their plan to cut rates in 2023, even indicating there were likely to be multiple smaller rate cuts during 2024 and likely beyond. However, their concerns about the level of inflation caused them to maintain the level of the Fed Funds Rate well beyond what most people had anticipated. So, with an interest rate reduction almost certain to come soon, in this issue of the newsletter, we want to highlight why so much attention is paid to interest rates from a larger financial perspective.

The Fed’s Role and Use of Interest Rates to Enact Policy
The Fed has a dual mandate with 3 primary objectives: maximum employment, price stability, and moderate long-term interest rates. The intent of the mandate is to drive a strong and stable economy where individuals who want to work can do so to adequately take care of their families. The Fed seeks to influence employment and inflation by using the tools at its disposal by altering the availability of capital in the money supply and by adjusting the cost of credit through interest rate changes. Since the level of unemployment has been relatively low for quite some time now since the heightened levels that occurred during the pandemic, the Fed’s major focus of late has been on getting inflation down to its targeted level of around 2%. That was the purpose of the series of interest rate increases that were enacted post-pandemic, and with inflation continuing to trend down closer to the desired target, the Fed is now seeking to determine the right timing to lower interest rates and how much to lower them.

How Interest Rate Movements Affect the Economy and the Stock Market
The overall goal for the Fed is to maintain a stable and growing economy. An ancillary item that goes along with that is a healthy stock market. While the Fed does not have levers to pull to directly impact the stock market, the steps it takes regarding economic growth tend to result in movement in the stock market because a growing economy will tend to benefit companies and with it their stock prices. However, the Fed’s impact on the economy does not always line up seamlessly with the stock market. The movement of the stock market reflects larger public sentiment of what is likely to come in the future, so stock prices tend to move in an anticipatory manner. Therefore, movements in the stock market will often happen in anticipation of what is expected, and if that expectation comes to pass, the trend often continues. On the other hand, if what is expected does not occur, the stock market will sometimes reverse course. As a result, the actions of the Fed often have a very swift impact on the stock market. By contrast, the actions of the Fed can take a significantly longer time to flow through the economy where it is actually felt by the public. For example, when the rate of inflation was in the 7-9% range in early to mid-2022, the Fed aggressively raised the Fed Funds rate by 3% from 0.25% in March 2022 to 4% in November of 2022. In subsequent months, they continued to raise the Fed Funds rate at a slower pace, up to 5.5% between the November 2022 rate hike and July 2023, which was the last rate increase in that cycle. During that time, inflation went from a high point of 9.1% in June 2022 to 7.1% by November 2022 and down to 3% by June 2023, and the rate of inflation had fallen to 2.4% by July 2024. While the impact of the rate increases slowly worked their way through the economy to lower inflation, the stock market made more dramatic shifts in response to actual and anticipated interest rate movements during that time, and as the rate increases ended and rate cuts were anticipated, the stock market has taken off since November 2023. Of course, there are other factors that have contributed to the growth of the stock market, but the expectations of interest rate movement has been in the background all the time.

What to Expect from an Impending Fed Rate Cut
When the Fed lowers the Fed Funds Rate, it will result in lower interest rates throughout the system. In turn, that tends to spur economic activity because businesses can borrow at lower interest rates and therefore engage in more investment activity to boost revenue, and consumers can borrow at lower interest rates to purchase goods and services. Mortgage rates will tend to drop as prevailing interest rates decline, allowing people to more affordably purchase homes. All of this is likely to take place when the Fed begins lowering rates, but it will take time to see that activity ramp up. If the Fed decides to lower rates at a faster pace, similar to the approach they took when they raised rates in 2022, the economic impact could be felt sooner. However, they have to walk a fine line in how much to lower rates because doing so too quickly has the potential of working against their goal of keeping inflation in the range that they want. From the perspective of the stock market, if history is a good indicator, should the rate decreases be slow and measured, there may not be a significant increase in the trajectory of the current stock market growth. It is even possible that there may be a slide in the stock market because rate cuts were less than anticipated. Much of the growth that has occurred of late has been in anticipation of coming rate cuts, so it may take bolder action on the part of the Fed to give the market an even greater boost in momentum. It is important for investors to always keep in mind that these stock market movements, whether in relation to interest rate policy or other economic activity, is cyclical and unpredictable. Therefore, it is wise not to place too much emphasis on what may happen in the stock market over the next quarter, six months, or even a year. Instead, it is wise to have longer term perspective, while using changes in the current environment to make small adjustments to take advantage of opportunities that may exist.

Stewardship Emphasis

There is always noise in the background, but if you can tune out the noise, you can better hear what is actually happening.

The Empowerment Channel    |   Volume CCXXIX   |    Dedicated to Promoting Financial Education through Stewardship