What Fed Rate Cuts Mean for Investors and the Broader Economy

The Federal Reserve announced a 0.5% rate cut on Wednesday, Sept. 18th, lowering the Fed fund rates to 4.75-5% from 5.25-5.5%. In a statement, the central bank said: “The Committee has gained greater confidence that inflation is moving sustainably toward 2 percent, and judges that the risks to achieving its employment and inflation goals are roughly in balance.” Going forward, markets are expecting additional cuts this year and through 2025, expected to total up to 1.5-2.5%. 

While uncertainties remain on the timing and size of additional rate cuts, the reasons for the rate cuts and the way the full rate cut cycle might play out are crucial to understand as an advisor and an investor. The implications may not be as straightforward as they seem, particularly as market expectations have shifted dramatically over the past year.

This piece explores how rate cuts have historically impacted the economy and markets, and how one may be impacted as an investor.

The Rationale Behind Fed Rate Cuts Is Important

 Figure 1:  Fed Rate Cut Cycles

The Fed typically lowers interest rates in response to a weakening economy, since doing so makes it cheaper for individuals and companies to borrow, while also increasing the incentive to spend rather than save. In theory, this move boosts growth and bolsters the financial system, especially during recessions and financial crises. Over the past few decades, the Fed made dramatic rate cuts during the early 2000s dotcom bust, the 2008 global financial crisis, and the Covid-19 pandemic in 2020.

How the economy and markets typically behave during rate cut cycles can be easily misunderstood throughout these historical references. While lowering rates is intended to promote growth, doing so during an economic crash means that a recession and bear market are likely to follow and last several quarters after the first cut. Historically, rate cuts have correlated with poor market returns – even though it’s important to recognize that rate cuts were in response to, rather than the cause of, these economic challenges. 

Conversely, while rate hikes are typically seen as slowing the economy, they often occur during economic booms and bull markets as the Fed slowly pumps the brakes. Thus, counterintuitively, rate hikes have historically corresponded to strong returns.

The Fed is not currently battling a sudden economic collapse or financial crisis, but is instead navigating a period of steady, but slowing, growth with improving inflation and a weakening, but still resilient, labor market. The current rate cuts live in a separate economic environment and are quite different from periods of emergency rate cuts. Thus, the rationale for lowering rates matters when considering how they might impact markets in the months and years ahead.

A more applicable example to the latest rate cut is the 1994-1996 rate cycle, when the Fed raised rates to combat inflation fears before lowering them again shortly thereafter. Periods like these are often referred to as “soft landings,” since the Fed arguably managed to cool the economy without triggering a recession. While there was a significant shock to the bond market – just as there was in 2022 – markets eventually responded positively to rate cuts once the economy stabilized.

The Fed’s Task Is to Balance Inflation and Growth

The Fed’s dual mandate, as described in the 1977 Federal Reserve Act, is “to promote maximum employment and stable prices.” Today, this is interpreted as returning inflation to 2%, while ensuring the economy continues to grow steadily.

Figure 2: Unemployment and Inflation

These objectives can conflict, since faster growth should, in theory, result in higher inflation. From 2009 to early 2020, inflation was nearly non-existent, allowing the Fed to keep interest rates exceptionally low, resulting in one of the strongest job markets in history. In contrast, the inflation of the past few years has required the Fed to make tough choices between price stability and the job market.

Fortunately, inflation has been improving since its peak in 2022. The latest Consumer Price Index (CPI) report showed that prices continued their gradual descent in August, with the headline index rising only 2.5% year-over-year. However, the Fed is hesitant to declare victory, since core CPI – which excludes volatile food and energy prices to measure the underlying trend – experienced a slight uptick to 3.2%. This increase was primarily due to stickiness in housing prices, which has been a point of concern for economists.

It's been said that monetary policy works with “long and variable lags.” In other words, if the Fed waits for inflation to fall back down to 2%, it may have already waited too long. The cost of doing so would be an over-tightening of the job market, which would have real-world consequences on households and businesses. The recent softening in the employment data provides further support for reducing rates.

Bond Yields Are Adjusting to Rate Cuts.

Figure 3: Treasury Yield Curve

Given these economic trends, most economists and investors believe the Fed will cut rates a few more times this year and throughout 2025. Bond yields have responded, with the yield curve “disinverting” for the first time since the rate hike cycle began in 2022. Short-term interest rates, which are tied to Fed policy, have begun to fall – while long-term interest rates, which are tied to economic growth, have not declined as much. The result is an “upward-sloping” yield curve, often seen as positive for the economy.

While the past is no guarantee of the future, lower rates have been positive for both stocks and bonds across history. Bond prices, in particular, move in the opposite direction of bond yields, which explains why many bond indices have rebounded in recent weeks.

For stocks, lower interest rates mean that businesses have access to cheaper financing for investment and expansion. When it comes to the math of valuing companies, lower rates mean that future cash flows are discounted less, which can result in more attractive prices today. Of course, the market never moves upward in a straight line; and investors should always be prepared for periods of volatility, as the financial system adjusts to Fed moves.

As we enter a new phase of monetary policy, economists will be closely monitoring these indicators, particularly those related to employment and growth. The Fed's challenge from here will be to calibrate its policy response to support the economy without reigniting inflationary pressures or creating imbalances in financial markets.