Fed makes the cut

For the first time since March 2020, the Federal Reserve cut interest rates, lowering its benchmark Fed funds rate 0.5% to a target range of 4.75%-5%:

While a month ago this larger cut (instead of 0.25%) may have constituted a surprise, in recent days market expectations shifted, giving a higher probability to a 0.5% cut.¹

When the Fed lowers rates, auto loans, credit card rates, and mortgages become more affordable, while companies pay less to borrow money. That can encourage both consumers and businesses to spend, which may then spur the economy.

From March 2022 to July 2023, the Fed raised rates from zero to a nearly 16-year high of 5.25%-5.5% to subdue accelerating inflation in the wake of the 2020 COVID shutdowns, as supply chain disruptions and aggressive government spending initiatives drove prices higher throughout the economy.

The Fed’s goal during the hiking cycle was to lower inflation without tipping the economy into recession. To date, they’ve succeeded. Now they confront a different challenge: lowering rates without reigniting inflation. While it has cooled significantly since its mid-2022 high, inflation is still above the Fed’s 2% target level.

However, although the economy remains solid, it has slowed—especially the labor market. That could mean the Fed faces the possibility of being “behind the curve”—that is, it may find it difficult to cut rates quickly enough to prevent a slowing economy from turning into a recessionary one. That may explain the central bank’s decision to start the easing cycle with a larger cut.

With most of the major US stock indexes at or near record highs, the market is currently pricing an “immaculate soft landing” for the economy, according to Morgan Stanley Wealth Management. But while the strategists remain cautiously optimistic about equities, they also highlight risks to this outlook that “investors should not dismiss:” slowing global growth, weak small business hiring and investment intentions, and a vulnerable US consumer. ²

Now that the long-awaited easing cycle has begun, markets may increasingly focus on the pace of Fed cuts, measured against the strength or weakness of the economy. The jobs picture is poised to remain at the center of the discussion. If it continues to weaken, markets could become impatient if the Fed adopts a slow and measured approach to lowering rates.

Note: The Fed’s next policy meeting is scheduled for November 6-7.

¹ CMEGroup.com. Target Rate Probabilities for 18 Sep 2024 Fed Meeting (FedWatch Tool). 9/18/24.

² MorganStanley.com. The GIC Weekly: Is the Fed Behind the Curve? 9/16/24.