By Mike Walden
Recently the Federal Reserve (the Fed) made headlines by reducing its interest rate for the first time since 2020. Most analysts applauded the cut, and households — especially those looking to borrow money — enjoyed a jolt of optimism.
But before you can decide what this means, and whether you should be smiling or frowning, a number of questions need to be answered. Why did the Fed change its interest rate? What reasons did the Fed have to reduce the interest rate? Are more cuts coming? What does the cut mean for the health of the economy? How does the cut affect the timing of big-ticket (home or vehicle) purchases? How does the Fed’s move impact investments? It will be my job in today’s column to try to answer these questions.
The Fed has a mandate from Congress to use its powers to guide the economy to two objectives: a low inflation rate and a low unemployment rate. The Fed also has two tools to achieve this dual goal: influence over interest rates and influence over the money supply.
The challenge for the Fed is that the two goals are often incompatible. A slow-growing economy usually leads to a lower inflation rate, but also to a higher jobless rate. In contrast, a fast-growing economy will generate more jobs and less unemployment, yet there is a risk rapid economic growth will lead to higher prices. Hence, while the Fed wants to achieve both modest price increases and low unemployment, it usually gives priority to only one of these goals.
During the height of COVID-19 in 2020, it was clear what the Fed’s goal was — get the economy growing after the COVID recession when the jobless rate reached 14%. Hence, the Fed pushed their key interest rate to zero and expanded the money supply by trillions of dollars.
With the benefit of hindsight, we now know the Fed kept their foot on the economic accelerator for too long. With consumer buying sharply increasing but supply-chain problems keeping shelves partially bare, the inflation rate began rising in 2021. Therefore, in 2022 the Fed shifted its focus to curtailing inflation by raising their key interest rate and pulling cash out of the economy. In under a year, the Fed raised their interest rate by over five percentage points. Consumer interest rates such as those for mortgages and credit cards jumped.
The Fed has been in anti-inflation mode until their recent meeting when the Fed board announced a one-half percentage point cut in their interest rate. Also, the Fed is now decreasing the money supply. With the annual inflation rate approaching the Fed’s goal of 2%, combined with indications of slower economic growth, reduced consumer confidence and an upward trend in the unemployment rate, the Fed is shifting its focus to their mandate of low unemployment.
On a practical level, what does the Fed’s policy mean for you? First, it means the Fed has some worry about the health of the economy. Thus far, the Fed has been able to achieve a lower inflation rate without plunging the economy into a recession. This is unusual because it is rare. Forty years ago when we had a similar inflation challenge, it took a severe recession to bring the inflation rate to a normal level. Although they are in a minority, some economists are still predicting a recession.
While Fed Chair Jay Powell did not make a clear statement about the future, he did hint that more interest rate cuts would be coming, possibly totaling a full percentage point by the end of 2025. The implication is that for those wanting to borrow, the low point in interest rates is likely not yet here.
Do all interest rates move in lockstep with the Fed’s interest rate? Not necessarily. Financial conditions in individual markets, such as the homebuying market, vehicle purchase market and personal credit market, affect their interest rates in addition to the Fed’s influence.
It’s also important to realize individual interest rates can move in anticipation of what the Fed is expected to do. This recently happened with mortgage rates, which fell weeks before the Fed’s anticipated rate cut.
Much of the media coverage of the Fed’s rate cut has focused on how it will help borrowers. While this is certainly important, the Fed’s policy also affects investment markets. For example, certificates of deposit (CDs) are popular low-risk investments. Expect those rates to fall as the Fed’s interest rate drops.
The relationship between the stock market and the Fed’s interest rate is more complicated and depends on how investors interpret why the Fed is changing their interest rate. If investors expect a Fed rate cut to lower the costs to businesses of borrowing, allowing them to sell more and earn higher profits, then a lower Fed interest rate should cause stock values to trend higher.
But the opposite could occur. If investors interpret a Fed rate cut as occurring because the Fed is worried about an impending recession, stock values could fall, especially if the economy weakens after the rate reduction is announced.
Hence, it’s a good idea for households to reevaluate their investments in light of the change in the Fed’s interest rate course.
While the Fed’s rate cut looks like a good move, when the reasons behind the cut, what it implies about the economy and the uncertain impacts on investments are considered, the reduction could be a net plus or it could be a net minus. Both you and I will have to decide.
Mike Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.
