More than two years after first taking steps to contain swelling inflation, the Federal Reserve (the Fed) has taken a step back, suggesting monetary policy decision-makers have confidence that inflation will continue to move closer to the Fed’s target, allowing them to turn some attention to economic growth.
At its September meeting, the bank’s Federal Open Market Committee (FOMC) trimmed the target range of the federal funds rate – effectively the baseline interest rate across the U.S. economy – a half of a percentage point to 4.75% – 5.00%, down from 5.25% – 5.50%. The Fed is expected to make additional reductions in time, with decisions informed by data on inflation, the rate of unemployment, consumer spending, labor productivity and other key metrics.
The Federal Reserve, the independent authority over U.S. monetary policy, is charged with two distinct and often competing mandates: to support price stability – understood as a steady, low rate of inflation – and full employment. After roughly two years trying to slow the economy with higher interest rates to dampen inflation, this action is expected to bolster the economy and prevent a further slowdown.
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How interest rates change economic conditions
The U.S. has a high-trust, credit-driven economy, so changes in interest rates have far-reaching effects. Investors and consumers may expect changes to:
Retail credit: Interest rates on new loans are likely to come down, including rates on mortgages, auto loans, securities based lending and home equity loans. Interest rates on existing variable rate loans, such as adjustable-rate mortgages and credit cards, may also decrease.
For those who took on a new traditional loan during this period of elevated interest rates, it probably won’t be worth the cost in fees to refinance, at least not yet, but the current consensus is that the Federal Reserve will continue lowering rates. However, don’t expect the near-zero interest rates of the early 2010s or 2020/2021 to return. They were a historical anomaly the Fed was slowly addressing before the pandemic forced a new tack.
Stocks: Lower interest rates are understood to support economic activity, so one would expect stock prices to increase. However, the market is forward looking – since this rate cut has been long expected, the potential gains from it may already be represented in current stock pricing.
What will likely be more evident is how lower interest rates help parts of the stock market bounce back from challenging conditions. Small- and medium-sized companies are seen as more reliant on cheap credit than large companies, so their stock prices have struggled compared to the mega-performant, mega-sized stocks at the top. Credit-sensitive sectors like real estate and utilities may also see a boost.
Bonds: Similar to interest rates in the retail credit market, bond yields will likely go down, but the slide may already be priced into the forward-looking market. Lower interest rates are a boon to institutional borrowers, but also to those who own bonds issued when yields were higher. The value of those higher-yield assets on the secondary market goes up as yields on newly issued bonds go down.
The economy: In the post-pandemic period, the U.S. economy has been unparalleled in its strength and resilience in the developed world. However, by the middle of this year, economic data started showing signs of a slowdown. Concurrently, the inflation rate continued to decrease after a first-quarter hiccup.
This gave Fed leaders the go-ahead to lower interest rates. By lowering interest rates now, the Federal Reserve is saying it’s confident inflation will continue to subside and they will attempt to cushion the slowdown in economic activity. This is meant to mitigate effects like slower job creation, slower wage growth and a loss in consumer confidence.
As we continue, we’ll see how the balance of these forces plays out. Despite the boost from lower interest rates, it’s likely the economy will continue to slow down, as monetary policy works with long and variable lags. However, currently, a dip into recession – a period of shrinking economic output – only seems like a narrow possibility.
Changes in inflation and interest rates have the power to upend seemingly bedrock assumptions about the market, risk and opportunity cost. For example, changes in interest rates can change the math behind decisions to pay off debt ahead of schedule versus expanding an investment portfolio. Inflation and interest rates can also change the risk profiles of different types of investments, and left unchecked, can leave investors in a position far outside their comfort zone, with either too much or too little risk.
If it’s been a while since you’ve checked in, now might be a good time to sit down with your financial advisor and review your financial plan, particularly where it pertains to debt, risk and retirement timing.
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