All Focus on the Federal Reserve - Part 2

The Federal Reserve is expected to cut interest rates tomorrow, the first time since March 2020. In light of this, we wanted to share a three-part blog on the rationale for a cut, the Federal Reserve’s underlying goal, and how rates, bonds, and stocks may react.

Here is a link to Part One if you missed it - be on the lookout for part three early Wednesday morning.

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.

Thanks for reading part two! Be sure to check back tomorrow for part three, which will discuss how rates and bonds may react.

Shean