Fed’s Big Rate Cut: Good or Bad for the Economy?
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In September, the Fed finally commenced with its long-anticipated monetary easing cycle with a jumbo 50 basis point rate cut. The markets were split as to whether the central bank would choose the gentler quarter-point cut or go with the larger half-point move out of the gate. The Fed members decided that conditions warranted a more aggressive cut but insisted that the economy was still in a healthy place.
Was the Fed’s decision to go larger the right one? We won’t know the answer to that one for a while, but there are several factors to consider.
The primary one is how healthy the economy is. Cuts or hikes bigger than a quarter-point could send the signal that the Fed may be trying to play catch-up. A good example of this would be 2022 when the Fed made multiple 75 basis point rate hikes to try to get inflation under control.
Chair Powell insisted in the post-meeting press conference that the U.S. economy was in good shape. At a high level, he probably has the data to support that notion. In the 2nd quarter, GDP rose at a 3% annualized rate. The unemployment rate is still well below 5%. Those numbers in isolation don’t really suggest an economy that’s in trouble.
If he’s right, there’s a case to be made that stock prices could keep moving higher. Historically, a healthy economy coupled with a rate cut has tended to be positive for stocks, especially those that are considered cyclically sensitive.
If economic conditions are on the decline, however, it could be ominous for equities.
Traditionally, central banks lower rates because they want to give the economy an assist. If GDP growth is healthy, inflation is under control and we’re at or near maximum employment (which you could argue is the case currently on all three counts), there may not be a need to cut rates at all, let alone by 50 basis points. And if the economy is in good shape, why is the latest Fed Dot Plot forecasting another 200 basis points of rate cuts by 2026?
This raises the question, of course, of whether or not the economy is really as healthy as Powell says it is. If it isn’t, consider that the last two times the Fed started cutting rates with a 50-basis point move were in 2001 and 2007.
Time will tell.
Let’s dig a bit deeper into what the Fed’s rate cut might signal and its potential implications for different sectors of the economy.
Why Such an Aggressive Cut?
A 50-basis point cut is a bold move, especially considering that inflation isn’t running rampant and the labor market remains relatively strong. One reason could be that the Fed wants to get ahead of potential trouble—perhaps signaling that the economy isn’t as strong as it seems on the surface. If so, this cut could be more of a preemptive strike to avoid a slowdown rather than a reaction to an existing problem.
Another possibility is that the Fed is responding to global economic conditions. With slowdowns in China and Europe, as well as geopolitical tensions, the Fed may be looking to insulate the U.S. economy from external shocks. Lower rates can help maintain domestic demand, encourage investment, and keep the economy humming even if growth abroad falters.
Impact on the Bond Market
The bond market’s reaction to this cut is crucial. Bonds often act as a barometer for future economic conditions. Following the rate cut, bond yields may fall, indicating expectations of slower growth ahead. Lower yields can benefit certain sectors like housing, where mortgage rates tend to follow Treasury yields. Homebuyers might find this environment more favorable, which could provide a boost to real estate markets.
However, if bond yields drop too far, it might signal that investors are bracing for a recession, especially if long-term yields fall below short-term rates, creating an inverted yield curve. Historically, an inverted yield curve has been a reliable predictor of recessions, though it’s not an immediate trigger.
Stock Market Reaction: A Mixed Bag?
For stocks, a rate cut often provides a short-term boost. Lower rates can reduce borrowing costs for businesses, increase consumer spending, and make equities more attractive compared to low-yielding bonds. However, not all sectors will benefit equally.
- Cyclical Stocks: These stocks, which include companies in industries like construction, retail, and transportation, typically perform well when rates are cut, especially if the economy is still growing. The Fed’s move could fuel optimism in these sectors.
- Financials: Banks and other financial institutions may not fare as well. Lower interest rates reduce the spread between what banks can charge for loans and what they pay for deposits, squeezing their profit margins.
- Technology: The tech sector could benefit from cheaper borrowing costs, allowing companies to invest more in innovation and expansion. However, tech stocks have already been under pressure from high valuations, and a more cautious outlook on economic growth could keep investors wary.
Potential Risks
Of course, rate cuts are a double-edged sword. On one hand, they provide stimulus, but on the other, they can signal that the Fed is worried about future economic growth. If investors lose confidence in the Fed’s outlook, it could lead to increased market volatility.
One risk is that the Fed might be starting a rate-cutting cycle without enough room to maneuver in the event of an actual recession. With rates already low by historical standards, the central bank has limited firepower if things take a turn for the worse. Moreover, a dramatic cut like this could fuel speculation in riskier assets, potentially inflating bubbles in sectors like tech or real estate, which could burst if the economy slows down.
Looking Ahead
As we wait to see how the economy responds to the Fed’s aggressive move, investors should keep an eye on several key factors. Inflation will remain a crucial data point, as will any signs of softening in the labor market. Global trade tensions and geopolitical risks also loom large, and further disruptions could have a ripple effect on the U.S. economy.
In the end, the Fed’s oversized rate cut is neither an unequivocal good nor bad thing—it all depends on how the economy evolves. The rate cut could serve as a timely cushion to keep growth on track, or it could be a sign that the central bank sees trouble ahead. Either way, both the markets and the economy are entering a period of heightened uncertainty.
Investors would do well to stay cautious, diversify their portfolios, and keep a close watch on the Fed’s next moves.
Sources:
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