What is the Potential Impact of the 2024 Fed Rate Cut?

After several weeks of speculation, Chairman of the US Federal Reserve, Jerome Powell, finally confirmed that interest rate cuts would be coming. This was revealed during a speech made earlier in August, when Powell stated “the time has come for policy to adjust,” signalling his confidence that the ongoing efforts to bring inflation under control is bearing fruit ^[1].  

The upcoming rate cut is expected to be made when the Federal Market Open Committee (FOMC) next meets on 18 September. It would mark a reversal in interest rate policy since COVID-19, which caused supply-side shocks that drove inflation in the US to highs not seen in decades. In response, the US Federal Reserve embarked on aggressive rate cuts in an attempt to bring inflation to heel – an endeavour that is now proving successful.  

In this article, we’ll discuss the likely impact of the interest rate cut on the US economy and what to look out for.  

Historic Rate Cuts and Their Impact ^[2,3,4] 

2019 to 2020 Rate Cuts 

The last round of rate cuts took place between 2019 and 2020, where interest rates were reduced five times in total.  

2019 saw three cuts of 25 basis points (bps, or 0.25%) each, for a total of 0.75 bps. These took place consecutively in August, September and November, and were largely driven by trade tensions with China. 

Back in 2018, former President Trump initiated a “trade war” with China, introducing tariffs aimed at reducing or eliminating the trade deficit between the two superpowers. China responded in kind, with the tit-for-tat battle continuing until 2020, where both sides eased off the pedal with the Phase One Deal.  

Concerned about the negative impact of trade war, the US Federal Reserve (or Fed) decided to cut rates to keep the economy buoyant. This proved to be a good decision, as inflation rates stayed below 2% in the latter half of 2019, and the first months of 2020.  

However, when the Covid-19 pandemic took hold, forcing widespread shutdown of economic activities and cross-border trade, the US economy quickly descended into weakness in 2020. In April alone, over 20 million jobs were lost, spiking the unemployment rate to 14.7%.  

In response, the Fed held emergency meetings to slash interest rates as a means to keep the economy from going under. Both cuts were implemented in March 2020, bringing the Federal Funds Rate all the way down to a range of 0% to 0.25%. 

2008 Rate Cuts 

The Great Recession of 2008 also saw the Fed taking similarly drastic action, dropping interest rates to the 0% to 0.25% range. This was the culmination of three massive rate cuts that took place in October twice, and once in December. The first two cuts dropped rates by 50 bps each, with the final one shearing off 100 bps.  

After the Federal Funds Rate fell to zero, the Fed could not cut rates any more. Thus, it also carried out quantitative easing, buying trillions of dollars worth of government bonds to further stimulate the economy and create jobs for consumers.  

What is the Historical Impact of Rate Cuts? 

To understand the long-term impact of rate cuts, it’s essential to first understand why central banks cut interest rates.  

Lowering interest rates brings down the cost of borrowing. This means debt becomes cheaper to afford, and loans, mortgages and credit cards become easier to repay.  

This is thought to encourage borrowing from businesses, allowing them to keep jobs open or even employ more people. Likewise, with credit easier to obtain, and jobs easier to find, consumers can continue to purchase goods and services, allowing the economy to chug along.  

When the economy is growing too quickly – mainly characterised by high inflation rate (typically, inflation over 2% is considered high) – central banks increase interest rates. This has the effect of making debt more costly, ultimately slowing down the economy.  

Therefore, central banks continually make interest rate adjustments as the economy cycles between growth and retreat. The aim is to keep things on an even keel as much as possible, so as to blunt the negative effects of the natural economic cycle.  

Accordingly, the long-term impact of interest rate cuts is simply to stimulate the economy when it falters, and bring economic growth back on track. And because inflation and interest rates are directly related, the historic impact of rate cuts is to bring inflation back down to a healthy level.  

What Is the Potential Impact of the 2024 Rate Cut? 

Why is the Fed Cutting Interest Rates now? ^[5,6,7,8] 

One nasty consequence of the pandemic was skyrocketing inflation levels, not only in the US, but around the world. This is thought to be caused by the severe disruption to the global supply chain experienced during Covid-19, driving prices up. 

In practical terms, when inflation is too high, it means prices are rising far faster than businesses and consumers can keep up with. Over time, this leads to an economic breakdown as nobody can afford to purchase goods and services any longer.  

Thus, when supply shocks drove inflation to record highs in the US – the Consumer Price Index (CPI) exceeded 9% in June 2022 – the Fed embarked on a series of interest rate hikes in order to bring inflation under control.  

Given that inflation in the US has now tamed – the CPI was 2.9% for the 12-month period leading up to July 2024 and that the job market remains resilient – the unemployment rate edged upwards to 4.3% as at 31 Jul 2024. The Fed is now convinced this is the right time to cut interest rates, beginning the move back towards normalcy.  

How much will the Fed Cut Rates, and What Factors Might Influence this Decision? ^[9,10] 

Let’s set the stage. Since March 2022, the Fed has implemented interest rate hikes a total of 11 times, leaving the Federal Funds Rate standing at 5.25% to 5.5%. While this is significantly higher than the ideal rate of 2.5%, the Fed has to be cautious, as cutting rates too much too fast could see inflation rising back up again, further straining the economy. 

Furthermore, the latest jobs report was weaker than expected, with unemployment rising slightly in July as mentioned earlier; this further precludes aggressive moves by the Fed, which is charged with the dual mandates of keeping inflation while maximising employment. 

Given these factors, analysts expect the Fed to move slowly, reducing the Federal Funds Rate by 25 basis points over the next three scheduled meetings in September, November and December. If this bears out, interest rates would fall to 4.25% to 4.5% by the end of the year.  

However, if the labour market continues to weaken, this could prompt more aggressive cuts of 50 basis points.  

As for the longer term, the Fed is expected to maintain a tight grip over interest rates throughout 2025 and 2026. Analysts are calling for interest rates between 2.5% to 3% over the period. 

How will the Fed Rate Cuts Impact the Economy? 

Impact on the stock market ^[11,12] 

In seeming defiance of current macroeconomic conditions, the stock market has charted an impressive rally. The S&P 500 is up a staggering 25% from August 2023, a mind-boggling feat considering the high Federal Funds Rate.  

This is a clear sign of investor confidence in the resilience of the American economy, but a Fed rate cut could turn out to be a double-edged sword. Cutting interest rates could create more liquidity in the stock market, potentially further driving up share prices.  

On the other hand, the rate cut – a move undertaken to stimulate a weakening economy – could be read as a sign of a lack of confidence on the part of the Fed, potentially prompting a stock market selloff as investors rush to lock in profits.  

Which way the stock market will go depends on how likely the Fed manages to pull off a “soft landing” – an ideal scenario where inflation continues to cool while the economy remains resilient. Investors are highly sensitive to this, as evidenced by the jump in volatility on the back of July’s weaker-than-expected jobs report. 

In contrast to the rally seen in the past year, the market crash in August 2024, highlights the fragility underlying investor sentiment. The rapid downturn triggered by global economic concerns serves as a stark reminder that market rallies can quickly reverse in response to unexpected economic shifts. 

Still, history has shown that the stock market tends to react favourably to rate cuts during times of economic resilience as opposed to economic weakness. Since 1970, the S&P 500 has climbed an average of 18% one year after the first rate cut in non-recessionary periods; during downturns, the index climbed an average of just 2% a year following the first cut.  

Impact on the bond market  

The US bond markets are expected to see near-term volatility in the wake of Fed rate cuts. As the interest rate of US bonds (aka the coupon) are based on the Federal Funds Rate, the current high interest rates have made them an attractive option for fixed-income investors.  

However, when interest rates are cut, newer bonds come with lower coupons. This makes current bonds more attractive due to their higher coupons, which may drive up their prices in the secondary market ^[13]. 

This also means future bond investors will have to contend with lower coupon rates, which could cause investors to withdraw from the bond markets in favour of higher returns.  

Impact on the forex market ^[14,15] 

A reduction in the Federal Funds Rate could trigger a US$ 1 trillion selloff of Dollar-denominated assets held by Chinese investors. This could, in turn, strengthen the Chinese Yuan against the Dollar by between 5% to 10%. 

This scenario stems from the theory that Chinese firms may have amassed more than US$ 2 trillion since the pandemic in offshore investments. This was to benefit from the higher interest rates offered compared to assets denominated in the Yuan, posited currency analyst Stephen Jen.  

Subsequently, when the Fed cuts the interest rate, weakening the appeal of the Dollar, Chinese investors would respond by offloading their Dollar-denominated assets in favour of a strengthening Yuan. According to Dr Jen, the outflow could rival the unwinding of the Yen carry trade in scope.  

This is a real-world example of how Fed interest rate cuts could impact the forex markets, and highlights the intertwined nature of forex exchange – currencies weaken or strengthen in relation to each other. That means the impact of interest rate changes is relative to what other central banks are doing.  

For another example, consider how the European Central Bank carried out interest rate cuts in June; meanwhile the US Federal Reserve held off on taking action in defiance of expectations. This widened the interest rate differential between both currencies, manifesting as the EUR weakening against the Dollar (or the Dollar strengthening against the EUR). 

Impact on the US economy ^[16] 

In general, the Fed rate cut could raise confidence among American consumers, buoyed by the prospect of cheaper debt accessible via credit cards, personal loans and mortgages. However, payroll figures would remain a major indicator, as consumers remain worried about high prices even amidst cooling inflation. 

As highlighted earlier in the article, reducing interest rates could prompt larger borrowing and increased consumption, with higher demand putting upwards pressure on prices. But this is unlikely to happen given the determination of Chairman Powell to keep a firm hand on interest rates as he aims for a soft landing. 

Provided there are no unexpected shocks or black swan events, the Fed’s approach of slow, gradual rate cuts should help rather than hinder the growth of the US economy in the near future.  

The tricky part is this. Researchers are beginning to believe that the main driver of inflation – supply-side shocks – has largely dissipated as underlying inefficiencies have been sorted out. Thus, the Fed may be moving too slowly, thereby inadvertently curtailing the prospects of the US economy. 

Conclusion: US Fed Cuts A Prelude to Greater Things? 

We’ve covered a lot of ground in this article, but this is unavoidable given the subject matter. While you may be pondering all the potential changes the Fed rate cuts may cause, know that this is overall a positive development.  

Keeping interest rates too high is detrimental to any economy, as doing so makes it difficult to access capital, throttling economic growth and squeezing investors out of potential returns. There must be a return to normalcy if economic growth is to continue. 

With the Fed finally admitting that it’s time to cut rates investors can look forward to a slow but sure return to normalcy in the US markets. And with the current market bullishness on display, the coming Fed rate cut could well be a prelude to greater things for all investors.  

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