What happens when the Fed cuts interest rates?

As the economic environment continues to evolve in 2024, the Federal Reserve

remains a central player in influencing financial markets and economic growth. Interest

rates, which are one of the Fed's primary tools, have experienced significant fluctuations

in recent years, especially in response to inflationary pressures and the aftermath of the

COVID-19 pandemic. When the Fed cuts interest rates, the ripple effects are felt across

the entire economy. Understanding these impacts helps investors, businesses, and

consumers make more informed financial decisions.

Lower Borrowing Costs: Stimulus for Consumers and Businesses

One of the most direct impacts of a Fed rate cut is the reduction in borrowing costs. In

September, after 11 rate hikes during 2022 and 2023 aimed at controlling inflation, the

Fed signaled a more accommodative stance in response to softening inflation and

slower economic growth. Lower interest rates reduce the cost of borrowing for both

individuals and businesses, spurring activity in sectors like housing, automotive, and

corporate investments.

For individuals, this means cheaper mortgage rates, lower interest on auto loans, and

more affordable credit card rates. In 2024, as the housing market stabilizes from its

earlier rapid growth, lower rates have once again made it easier for first-time buyers to

secure affordable financing. Similarly, businesses benefit from lower interest costs,

which can lead to expansion, capital investments, and increased hiring.

Encouraging Consumer Spending: A Key Economic Driver

Consumer spending is a critical component of economic growth, accounting for nearly

70% of U.S. GDP. When the Fed cuts interest rates, it makes borrowing cheaper, which

typically encourages consumers to take out loans or finance major purchases. In 2024,

lower borrowing costs have provided relief to consumers facing elevated costs for

goods and services due to lingering inflation. As inflation moderates, lower rates have

helped offset some of these costs, encouraging more discretionary spending on items

such as homes, cars, and luxury goods.

The Fed's likely rate cuts in 2024 and beyond will also aim to ease the debt burden on

households that accumulated higher levels of credit card debt during the pandemic

recovery and inflationary surge. Easing rates has led to somewhat of a stabilizing effect,

helping avoid a more pronounced economic slowdown while boosting retail sales and

consumer confidence.

Impact on Savings: Challenges for Savers Continue

While rate cuts are beneficial for borrowers, they tend to have a negative impact on

savers. The Fed’s recent 50 bps rate cut has already impacted the return on traditional

savings vehicles such as savings accounts, certificates of deposit (CDs), and Treasury

bonds. While these more conservative investment vehicles still offer attractive yields,

the Fed’s actions in the coming months could give way to a landscape where cash is no

longer an attractive alternative to traditional securities like stocks and bonds.

Stock Market Response: A Bullish Reaction, But With Caveats

The stock market has typically responded positively to the anticipation of interest rate

cuts, and 2024 has been no exception. Lower rates tend to reduce the cost of capital for

businesses, boosting corporate profits and, by extension, stock prices.

Interest rate sensitive sectors have historically been the beneficiary of anticipated

interest rate cuts by the Federal Reserve. Homebuilders, for example, have outpaced

the S&P 500 due to the expectation that lower mortgage rates will unleash pent-up

demand for new housing starts. Consumer discretionary companies could also stand to

benefit from ongoing rate cuts as lower borrowing costs may allow consumers to

increase their consumption of non-essential goods. Historically, Small-Cap companies

also benefit from rate cuts as these less-mature companies tend to have higher debt

levels than their Large-Cap counterparts.

Keep an Eye on Inflation

When the Fed cuts interest rates, it increases the money supply, encouraging spending

and investment. However, if done too aggressively, rate cuts can reignite inflationary

pressures. The Fed will be walking a fine line between supporting economic growth and

avoiding a return to higher inflation. Investors should keep an eye on inflation metrics,

as they will be key to determining the pace and magnitude of future rate adjustments.