Interest Rate Cuts: Meeting An Uncommon Historical Moment

We’re entering into an unusual moment in history. The Federal Reserve is set to lower interest rates within weeks of this writing. Fed Chair Powell said as much, expressing that “the time has come” for cuts at a recent FOMC press conference (source: CNBC). We’re getting rate cuts not because we’re in dire economic straits, which is usually the case when cuts are imminent, but because both economic growth and inflation have slowed enough to warrant a policy reversal. A rate cut, of any size, will be the first since March 2020. 

Did the Federal Reserve wait too long to lower rates?

The implication of waiting too long to cut rates is that the Fed fought inflation at the cost of actively hastening a recession. We won’t know for sure whether the Fed waited too long for another 1 to 2 years. Economists work primarily with lagging indicators. The results of monetary tightening policies (i.e. higher interest rates) can’t be fully quantified until time passes, the economic effects play out, and the data are sorted.

Will the Fed lower rates aggressively, or ease into it?

In other words, will we see a more aggressive approach from the Fed -- like 0.50% or 0.75% cuts at this next meeting -- or will they take it easy and merely cut 0.25%? It appears for now that the Fed will merely dip its toe in the water, rather than dive in, on September 18th. We expect Chair Powell and FOMC members will aim for a small rate cut. Expect cuts to be made gradually. But don’t be fooled by a gradual monetary policy. Even if the Fed cuts rates by only 0.25 points at each successive meeting going forward, it’s worth noting that the FOMC meets 8 times a year. In other words, in this scenario, that equates to dropping rates by a full 2 points (0.25 x 8) by summer of 2025. We can’t know what the approach will be, of course, but I mention this because this example is certainly plausible.

Why is the Fed cutting rates now?

Unemployment numbers have risen to 4.3% (Source: Forbes). The rate of inflation is also steadily declining, which means the dollar's value is stabilizing. At the end of July, CPI was 2.9% (Source: Inflation Calculator). This was enough for the Fed to start turning the ship around and begin the process of cutting rates. 

While more tangentially related to the overall economy, the broader market has what some observers call a case of “bad breadth” – that is, an uneven dispersion of companies that are outperforming their index. What we see is that a handful of mega companies account for the lion's share of returns, while many other, historically profitable businesses have struggled to keep up.

This explains why S&P 500 earnings growth, which has long been dominated by the giant tech firms, continues to rise while, at the same time, many other businesses are only getting by. In addition, many of the Mid-Cap or Small-Cap companies do not have a war chest like many of the Big Tech firms do to get through challenging times. The non-Big Tech, lesser-known businesses can also be more interest rate sensitive, so a cut in interest rates could certainly help returns broaden out. 

The Federal Reserve understands that the economy is more than Amazon and Apple, so they’re finally concluding that this is the appropriate time to loosen up the reigns and lower rates. If they’ve timed it right, which it seems they have, now is the time to institute more of an economic expansionary policy to ward off any potential threat of recession.

This inflection point should serve to bolster the economy and help businesses. We believe this is a great time for long term investors to remain invested, especially in U.S. companies.

By Jonathan Cameron, CFP®

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Photo by Paul-Alain Hunt on Unsplash