Rate Cuts: Good or Bad?
By: Aaron Anderson, CFP®, CFA, Managing Partner
September 27, 2024
One of the previous chairs of the Federal Reserve, Alan Greenspan, once said, “If I seem unduly clear to you, you must have misunderstood what I said.” The current Federal Reserve chair tries to take the opposite approach and broadcast his plans as clearly as one can when trying to predict future economic conditions.
As we’ve discussed previously, the Federal Reserve had been raising interest rates to try to get inflation under control. About six months ago, they stopped raising rates and started hinting that a rate cut was forthcoming.
That well-broadcasted rate cut finally came last week. The thing that surprised many Fed observers was that they cut ½ a percentage point when a smaller ¼ percent cut was expected. While that doesn’t seem like a big deal, the cut was double the expectation and changes the expected glide path of future cuts.
Is this rate cut good or bad? So far, the market seems to be leaning toward the optimist camp, but it depends on who you ask.
Optimist
The optimist would say this is great for the economy. We only have to look at the 40 years from the early 1980s through the early 2020s to see the evidence. Although there are times where the market and interest rates went up concurrently, most of the time a decrease in rates led to better market returns.[1]
When the Federal Reserve lowers the Fed Funds rate, other interest rates in the economy follow. Businesses can get cheaper loans to make capital improvements, homeowners who bought recently at high rates can refinance, the Federal government pays less tax revenue toward interest on new debt, more small businesses can get off the ground.
Less money paid in interest leaves more money available to be spent on goods and services. From an investor’s perspective, that can lead to higher company revenues, higher earnings, and the higher stock prices that tend to follow. With inflation in check and people feeling wealthier, they spend more creating a positive feedback loop.
Pessimist
The pessimist would say that if the economy was in such good shape, then the Fed should have no need to cut rates. Cutting rates is stimulative, a strong economy doesn’t need it. It’s like giving candy to a child – they get the sugar rush and then need a nap. So, maybe there really are cracks in the economy. For example, while unemployment is still near historic lows, it’s been trending up over the last year.
Of the six cutting cycles since 1990 (excluding during Covid), the economy went into recession an average of 18 months later with the shortest start just two months later (Optimist interjection: the longest one was almost six years later!).
There is still concern of possibly repeating the 1970s. Finally, even though loans are available at a lower rate, the interest paid on deposits is also lower. Savers are punished in this scenario. So, as an investor, rate cuts may not be as beneficial as they initially seem.
As with most things, the truth is likely somewhere in the middle.
Like many of you were probably thinking, both sides make good arguments. We all see things through our personal filters, even when looking at the same information. “That’s what makes a market” as the saying goes. Everyone who thinks a stock is good enough to buy needs a seller who thinks it’s not worth owning anymore.
Long term optimism has been the winning strategy when it comes to investing. People joke that the pessimists have predicted 11 of the past five recessions. Search back to articles from late 2022 that said we were heading into a recession in 2023. I’ll choose this one as a representative – not only did we not have a recession last year, but the market is up almost 50% since then.
Although the economy doesn’t seem to be showing signs of it so far, the pessimists might be right and a recession could occur. Problem is that we don’ t know when or for how long. Looking at market history, while pessimism might win the short-term battle on occasion, optimism tends to win the long-term war.
[1] The source of the chart goes into much more detail. There are other factors that contributed such as computers becoming commonplace in the 1980s and 1990s followed by the Internet revolution in the early 2000s leading to increased productivity. While rates stayed flat at low levels in the 2010s, quantitative easing (QE on the graph) increased money supply through the Fed's bond buying program.
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