What Happens After A Fed Rate Cut?

And at the ninth FOMC meeting, there was a rate cut.

During the September 2024 FOMC meeting, Fed Chair Jerome Powell and the FOMC voted to lower the target Fed Funds rate range by 50 basis points to 4.75-5.00%, marking a shift in stance after maintaining a target range of 5.25-5.50% at the last eight meetings. This period, dubbed “higher for longer,” spanned almost exactly 12 months.

A year ago, after raising in July 2023, observers correctly forecasted the Fed Funds rate to remain unchanged heading into the September 2023 meeting. The Fed would continue to hold its key overnight borrowing rate at 5.5% for the next seven FOMC meetings amid a strong labor market and an effort to tame inflation.

During the Fed’s hawkish period starting in March 2022, US Inflation has dropped from a more than 40-year high of 9.1% down to 2.5%. While the latest inflation print remains above the Fed’s 2% target, “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,” according to the latest Federal Reserve statement.

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On the surface, the Fed Funds Rate may seem like just one interest rate out of the many in our complex financial world. While its main purpose is to set short-term borrowing costs for banks, it also influences rates on consumer products such as, savings accounts, mortgages, and credit cards.

Effects of changes to the Fed Funds Rate also spill over into financial markets. There’s even an old investing mantra that goes, “Don’t Fight the Fed,” meaning it would be wise to align your investment choices with the actions of the Fed.

With that in mind, how powerful are the Fed’s decisions regarding monetary policy? What effects do those decisions cast, and how do financial markets and sectors of the economy react to changes in the Fed Funds Rate? What might the end of the hawkish cycle–and beginning of a dovish era–mean for investors?

What is the Federal Reserve and the Fed Funds Rate?

The Federal Reserve was created in 1913 under President Woodrow Wilson through the Federal Reserve Act. Known as “the Fed” for short, the central bank of the United States serves several purposes, ranging from promoting stability in the financial system to regulating financial institutions and their activities. One of the Fed’s primary functions is setting U.S. monetary policy to achieve its “dual mandate” set by Congress: maximum employment and long-term price stability in the United States.

Monetary policy is set by a body within the Federal Reserve called the Federal Open Market Committee (FOMC). The FOMC usually meets eight times a year to review economic and financial conditions and vote on changes to monetary policy. Policy is typically implemented through changes to the Fed Funds Rate, the benchmark rate at which financial institutions lend to each other.

If the FOMC deems that macroeconomic events warrant an increase to the Fed Funds Rate, such as inflation outpacing the Fed’s long-term target of 2%, the committee will raise the Fed Funds Rate to prevent the economy from overheating. If the economy appears to be stalling, the FOMC may attempt to spur economic growth by lowering its target rate.

Whether the FOMC votes to raise the Fed Funds Rate, lower it, or keep it unchanged, each decision produces winners and losers throughout the economy. So which assets are most impacted by changes to the Fed Funds Rate?

How Bonds Are Affected by Fed Rate Cuts

Short-term Treasury Bills and the yields they can offer are most directly affected by the Fed’s monetary policy, as stated by the Fed.

Though any fixed-income instrument is subject to the ebbs and flows of the open market, short-term treasuries have historically moved in near lockstep with the Fed Funds Rate. This relationship is strongest for the 1-Month, 3-Month, 6-Month, and 1-Year T-bills.

Longer-term treasuries, like the 10-Year Note and 30-Year Bond, don’t typically follow the Fed Funds Rate as closely, though they have trended along its general direction over the last 30 years. This is because the Fed does not directly target long-term interest rates, and the maturities on these instruments are denoted years or even decades out in time.

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The market values of bonds typically increase as rates go down. In a falling rate environment, newly-circulating bonds offer lower interest payments which in turn cause previously-issued instruments with higher coupon rates to rise in price. If further rate cuts are issued, prices of existing bonds could gain additional value, as their yields become increasingly valuable in comparison to newer offerings in a lower rate environment.

How Consumers Are Affected by Fed Rate Cuts

Prime Loan Rate

The Prime Loan Rate measures the rate at which banks lend to their most creditworthy clients. A rule of thumb for calculating the Prime Loan Rate is:

Target Fed Funds Rate + 3 points = Prime Loan Rate

The US Bank Prime Loan Rate is strongly correlated with the Fed Funds Rate. As seen in the chart below, the recent 50 basis point Fed rate cut has brought the current Prime Loan Rate to 8%, half a percentage point below its highest level in over 20 years. Any further Fed rate cuts are likely to lower the Prime Loan Rate by a proportional amount, leading to lower borrowing costs and thereby stimulating economic activity.

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Credit Card Interest

Changes to the Fed Funds Rate can also influence credit card interest rates, also known as Annual Percentage Rate (APR).

The relationship between the Fed Funds Rate and credit card interest rates is historically mixed, with most card rates tied to “Prime +” and issuers having some discretion on how quickly they adjust. Credit card interest rates came down only slightly when the Fed cut rates to 0% in 2020, unlike previous low or zero-interest periods. On the other hand, average APR rose along with the Fed Funds Rate in the two most recent rate hike cycles, reaching a peak of 21.59% in Q1 2024.

APR was virtually unchanged between Q1 and Q2 2024 as the Fed Funds Rate remained at 5.5%. Rate cuts could signal the end (or reversal) of rising APRs, providing relief to credit holders and encouraging consumer spending.

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Mortgage Rates

The prevailing 30-Year Mortgage Rate, and its 15-Year counterpart, tend to follow the 10-Year Treasury Rate more so than the Fed Funds Rate. Mortgages are backed by bonds and securities, which align more with an instrument like the 10-year treasury. The Fed doesn’t directly target long-term instruments, but since rates of most shapes and sizes experience a ripple effect from the Fed’s actions, mortgage rates tend to do the same.

The 30-Year mortgage rate surged to a peak of 7.80% in October 2023, five whole percentage points above its low of 2.65% in January 2021 before the rate hike cycle commenced. Mortgage rates have steadily fallen from highs while the Fed paused rate hikes over the last year. Additional rate cuts could lead to more favorable mortgage conditions for homebuyers.

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Savings Accounts & CDs

One group that stands to be at a disadvantage from Fed Rate cuts is savers, or depositors. When banks compete for individuals’ deposits, they often incentivize potential customers by raising interest rates on savings accounts and certificates of deposits (CDs). CD rates rose in response to Fed rate hikes in 2015 and through 2019, though they fell to extreme lows when the Fed Funds Rate went to zero in 2020.

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During this rate-hiking cycle, many investors took advantage of competitive yields and parked cash in money market funds–to the tune of $970 billion in 2023, according to YCharts fund flow data.

With the recent rate cut, savers might see a period of stalled interest rates on savings accounts and CDs, as banks would have less incentive to compete for deposits with higher rates. In response to the potential for slower growth of interest rates, individuals with longer investment horizons or greater risk tolerance could potentially seek alternative investment options to achieve better returns, which might impact the overall investment landscape.

Speaking of another investment option that often benefits from rate cuts…

How Stocks Are Affected by Fed Rate Cuts

As opposed to the negative impacts for businesses related to a higher cost of capital associated with higher interest rates, the Fed lowering rates typically plays out in lower borrowing costs to support expansion and capital expenditures. Additionally, rate cuts can stimulate consumer spending helping with top-line growth.

For these reasons, rate cuts are often looked upon favorably by equity investors. Looking at the charts below, you can understand why: stocks have thrived historically after rates were lowered and in previous low-rate environments. The stock market started picking up steam as the Fed Funds Rate fell from its peak in 1981, and the S&P 500 has risen 9.18% on an annualized basis since then.

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A pause in rate hikes could help maintain or even boost current market momentum, offering opportunities for investors to capitalize on equities, and providing companies with more attractive financing options. The index immediately popped 1.7% the day after the rate cut announcement on September 18th, supporting a positive narrative on the impact of rate cuts for equities. The longer-term impact for equities may be tied to whether the Federal Reserve can navigate a soft-landing for the economy.

Economic Indicators and Rate Cuts

Given that the Fed’s objective is to achieve a dual mandate of maximum employment and long-term price stability, FOMC officials factor a wide breadth of economic indicators into rate decisions.

Inflation

Changes to the Fed Funds Rate can be viewed as reactionary measures to maintain price stability. When inflation rises to far above the Fed’s 2% target, the Fed often takes action in the form of rate hikes to combat inflation. Conversely, when inflation falls back toward 2%, the Fed historically issues rate cuts as the institution deems that inflation has been sufficiently brought under control. We recently explored the Fed’s approach to managing inflation with a goal of long-term price stability and its impact on asset prices.

The following long-term chart comparing the Fed Funds Rate to inflation shows that the former often follows the latter’s lead, indicating the Fed’s use of the rate as a tool to help reel in inflation:

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Employment

Regarding the second part of the Fed’s dual mandate, shifts in employment indicator patterns often lag behind Fed Funds Rate movements. Unemployment tends to rise following rate hike cycles, then falls some time after rates are cut:

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Total payrolls have often taken a dip following rate hike cycles, but job gains surge for prolonged periods in lower-rate environments:

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GDP

Though lower rate environments have accelerated U.S. GDP growth, American economic output has, for the most part, been able to withstand the Fed’s actions over time. The most noticeable GDP contractions have occurred during recessionary periods; intuitively, this makes sense as two consecutive quarters of negative GDP growth is often cited as an element of a recessionary period (though not the sole determinant). Even though concerns over a forthcoming recession still loom, historical GDP figures show that the economy has a proven ability to thrive longer-term even when downturns occur.

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What Happened to Stocks When the Fed Funds Rate Was Last Cut by 50 Basis Points?

Interestingly, rate cuts of 50 basis points or more occurred at the onset of the last three recessions.

In the year following the initial half percentage point rate cut on January 3rd, 2001, the S&P 500 fell 13.5%, sinking as much as 28.3% within that span, reflecting the impacts of the bursting dot-com bubble.

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Six and a half years later, the Fed’s first rate cut in the wake of the Great Financial Crisis was a 50 basis point cut that took place on September 18th, 2007. The S&P 500 shedded 20.6% in the one year period that followed.

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Fast forward to March 3, 2020, and the Fed issued a 50 basis point cut in response to the recessionary effects stemming from the evolving COVID-19 pandemic. The Fed had already begun trimming the Fed Funds Rate starting in July 2019, coming down from 2.50% in quarter percentage point increments over its next three meetings, then holding the target range at 1.50-1.75% for another three meetings before deciding on a half percentage point cut. The S&P 500 plummeted as much as 28.5% in less than a month but proceeded to make a sharp V-shaped recovery and turn positive over the full 12 month period following the 50 basis point cut.

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The Bottom Line

The Fed marked the end of an aggressive rate hike cycle at its September 18th, 2024 FOMC meeting by cutting its benchmark Fed Funds Rate as prices show signs of stabilization within the Fed’s target range. Further rate cuts could cause a variety of effects throughout financial markets. Some areas of the economy felt head-on impacts from the Fed Funds Rate, while others experienced lighter effects.  It pays to know the impacts of the Fed Funds Rate so you don’t find yourself “Fighting the Fed.”

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