Fed Rate Cuts - Explained in Simple Terms
Layman's terms
The Federal Reserve’s (Fed) 50 basis-point interest-rate cut is a momentous moment in financial markets. Federal Reserve rate cuts refer to when the central bank of the U.S. lowers the interest rates it controls. These rates affect the cost of borrowing money for banks, which in turn impacts how expensive it is for people and businesses to take out loans.
What Is the Fed?
The Federal Reserve is like the U.S. government's bank. Its job is to make sure the economy stays healthy. One of the Fed's most important tools is its ability to set interest rates, which are the cost of borrowing money. These rates influence how much people have to pay when they borrow money for things like buying a house, starting a business, or even using a credit card. The Federal Reserve System has been given a dual mandate—pursuing the economic goals of maximum employment and price stability (low inflation).
What Is a Rate Cut?
A rate cut happens when the Fed decides to lower the interest rates. The Fed does this because it wants to encourage more people and businesses to borrow and spend money. When interest rates are lower, it’s cheaper to borrow money. For example, if the rate is 5%, and it gets cut to 2%, you’ll pay less in interest when you take out a loan.
Rate cuts are usually used during times when the economy is struggling. If people aren’t spending enough or businesses are laying off workers, the Fed might cut rates to stimulate growth. By making borrowing cheaper, it hopes people will spend more, companies will expand, and the economy will pick up.
Why Does the Fed Cut Rates?
There are a few reasons why the Fed might cut rates:
To Boost Economic Growth: If the economy is growing slowly, lowering interest rates makes it easier and cheaper for people to borrow money. This encourages spending and investment, which can help speed up economic growth.
To Lower Unemployment: Lower rates can help businesses by making it cheaper for them to take out loans and invest in hiring more workers. This helps reduce unemployment.
To Increase Inflation: Inflation is the rate at which prices for goods and services increase. The Fed often aims for a steady inflation rate around 2%. If inflation is too low, the Fed might cut rates to encourage spending, which can push prices higher and keep the economy moving forward.
Why Did the Fed Cut Rates this time?
The Federal Reserve cut interest rates yesterday for the following key reasons:
Slowing inflation: The Fed has gained confidence that inflation is moving closer to its 2% target, allowing them to ease monetary policy.
Weakening labor market: Recent data has shown slowing job growth and a slight increase in unemployment, prompting concerns about the labor market.
Preventing recession: The Fed aims to achieve a "soft landing" by lowering rates to prevent a potential recession while still keeping inflation under control.
Global economic concerns: The rate cut is also a response to broader economic uncertainties and slowing growth in other parts of the world.
The Fed implemented a larger-than-expected 50 basis point cut, bringing the federal funds rate to a range of 4.75% to 5%. This marks the first rate cut since the early days of the COVID-19 pandemic in 2020. Fed Chair Jerome Powell stated that this action demonstrates the Fed's "strong commitment" to restoring price stability without causing a significant increase in unemployment. The Fed also signaled the possibility of additional rate cuts later this year, with projections suggesting up to 100 basis points in total reductions by the end of 2025. This decision is expected to have wide-ranging effects on various aspects of the economy, including mortgage rates, credit card interest, savings account yields, and overall economic growth.
What is next?
The most recent, and I believe the only, precedents for 50 basis point rate cuts to begin an easing cycle are:
1. 2001 the Dot-Com Crash
Context: Following the burst of the dot-com bubble and the economic slowdown, the Fed cut rates multiple times, including a 50-basis-point cut in January 2001.
Market Reaction: The stock market initially rallied on the news of the cuts, but the broader economic conditions remained weak. The S&P 500 experienced continued volatility, ultimately dropping significantly.
2. 2007-2008 the Financial Crisis
Context: In the lead-up to the 2008 financial crisis, the Fed cut rates by 50 basis points in September 2007 as signs of stress in the financial markets emerged.
Market Reaction: Initially, the stock market responded positively, with the S&P 500 and other indices rising as investors saw the Fed’s action as supportive. However, the gains were short-lived as the financial crisis deepened, leading to severe losses in the equity markets throughout 2008.
With that said, I don’t think we are anywhere near the two preceding moments in history. The inevitable wall of worry that is going to be established by the two moments in time will most likely help equities and bonds this time. I believe for the remainder of the year we will see an additional 50 basis point cut by the Fed, in 25 basis point increments over the following meetings.
“Misconceptions play a prominent role in my view of the world.” ― George Soros