All Focus on the Federal Reserve - Part 1
The Federal Reserve is expected to cut interest rates this Wednesday, 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 part one - be on the lookout for part two on Tuesday and part three early Wednesday morning.
The Federal Reserve's interest rate decisions remain a focal point for markets. While the timing and size of rate cuts are the subject of debate, why the central bank is cutting rates and how the full rate cut cycle might play out are far more important. This is because the implications are not as straightforward as they might seem, and market expectations have shifted dramatically over the past year.
What should investors know about how rate cuts have historically impacted the economy and markets?
The rationale behind Fed rate cuts is important.
The Fed typically lowers interest rates in response to a weakening economy, since doing so makes it cheaper for individuals and companies to borrow, while also increasing the incentive to spend rather than save.
In theory, this boosts growth and supports the financial system, especially during recessions and financial crises. Over the past few decades, the Fed made dramatic rate cuts during the early 2000s dotcom bust, the 2008 global financial crisis, and the pandemic in 2020.
How the economy and markets typically behave during rate cut cycles can be easily misunderstood from these historical episodes.
While lowering rates is intended to promote growth, doing so during an economic crash means that a recession and bear market are likely to follow and last several quarters after the first cut. This means that rate cuts are historically correlated with poor market returns even though it’s clear that rate cuts were in response to, rather than the cause of, these challenges.
Conversely, while rate hikes are typically seen as slowing the economy, they often occur during economic booms and bull markets as the Fed slowly pumps the brakes. Counterintuitively, rate hikes have historically corresponded to strong returns.
Today, the Fed is not battling a sudden economic collapse or financial crisis, but is instead navigating a period of steady but slowing growth with improving inflation and a weakening but still strong labor market. In other words, the current situation is quite different from periods of emergency rate cuts. This is why the rationale for lowering rates matters when considering how they might impact markets in the months and years ahead.
Perhaps a more applicable example is the 1994-1996 rate cycle when the Fed raised rates to combat inflation fears before lowering them again shortly thereafter. Periods like these are often referred to as “soft landings” since the Fed arguably managed to cool the economy without triggering a recession. While there was a significant shock to the bond market – just as there was in 2022 – markets eventually responded positively to rate cuts once the economy stabilized.
Thanks for reading part one! Be sure to check back tomorrow for part two, where we'll dive deeper into the Federal Reserve’s goals and how they guide interest rate decisions.
Shean