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Key takeaways
At its mid-September meeting, the Federal Reserve is likely to cut interest rates for the first time since 2020.
The Fed’s policymaking Federal Open Market Committee (FOMC) hasn’t changed interest rates since July 2023.
The market’s primary question is how far and fast the Fed may cut rates.
Long-awaited cuts to the federal funds target rate controlled by the Federal Reserve (Fed) appear likely this month. The policymaking Federal Open Market Committee (FOMC) meets on September 17-18 and is expected to lower interest rates at that meeting. It would represent the first Fed rate cut since 2020.
“Investor expectations have really consolidated around a rate cut being priced into the Fed’s September meeting,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.
Markets have anticipated such Fed action for months, but rate cut speculation increased after a disappointing July labor market report showing rising unemployment and slowing job growth. During that same month, inflation fell below 3%.1 Fed Chair Jerome Powell appeared to confirm the Fed’s September plans, saying in late August “The time has come for (interest rate) policy to adjust.” Powell noted that, “The upside risks to inflation have diminished. And the downside risks to employment have increased.”2
“Investor expectations have really consolidated around a rate cut being priced into the Fed’s September meeting,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “We’re seeing signals from asset prices confirming a broader, gradual deceleration of the fed funds rate as well as a focus on worldwide rate cuts,” from other central banks.
“Investor expectations have really consolidated around a rate cut being priced into the Fed’s September meeting,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “We’re seeing signals from asset prices confirming a broader, gradual deceleration of the fed funds rate as well as a focus on global rate cuts,” from other central banks.
What drives Fed interest rate decisions
Since early 2022, the Fed has focused on inflation, with interest rate policy designed to slow the rapid rise in living costs. Inflation, based on the Consumer Price Index (CPI), has declined considerably, from more than 9% for the 12-month period ending June 2022, to 2.9% for the 12 months ending July 2024.1
However, the state of the job market is taking on increasing importance, says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The keys to what the Fed does now are labor market data. While the August jobs report will provide telling information, the Fed looks at multiple data points over time, not a selected point in time.” Haworth notes that initial jobless claims provide a helpful “real-time” guide on the state of the jobs environment. “Initial claims continue to hold within a modest range, which shows that the labor market remains stable for now,” says Haworth. Initial jobless claims in mid-August were below the level from the same period one year earlier.3
Markets are sensitive to the Fed
Markets suffered a temporary setback in the immediate wake of July’s weaker-than-expected jobs report. The S&P 500 declined nearly 9% below its mid-July peak, while the NASDAQ Composite Index fell into market correction territory (a decline of 10% or more from peak levels). Investors were concerned that the Fed’s failure to cut interest rates at its July meeting put the economy at risk. But other economic data released since that point seemed to allay those fears.
As a result, stocks quickly regained lost ground, and by late August, the Dow Jones Industrial Average topped its all-time record. The S&P 500 and NASDAQ Composite indices remain only modestly below their respective July peaks.
How fast will the Fed cut rates?
The CME FedWatch Tool, which analyzes the probabilities of fed fund rate changes based on interest rate trader actions, indicates a high likelihood of a 0.25% rate cut at the FOMC’s September meeting. A smaller number of traders project an initial rate cut of 0.50%.4
“The question for the Fed is whether they are focused on normalizing rates and cutting at a slower pace, or jump-starting cuts to change the environment more quickly,” says Haworth. “Based on what we know now, a 50-basis point (0.50%) rate cut would be a surprise.” Haworth says the markets prefer the Fed sends clear signals prior to making its interest rate policy decisions. He will be keeping a close eye on comments by Fed officials leading up to September’s FOMC meeting.
Reducing the Fed’s balance sheet
Dating back to the financial crisis of 2008, the Fed has routinely purchased bonds to bolster market liquidity. However, starting in March 2022, the Fed began reducing its bond holdings. In June, the Fed adjusted its policy, slowing the reduction in its Treasury holdings from $60 billion per month to $25 billion per month. The Fed continues to trim its holdings of mortgage-backed securities by $35 billion per month. “It appears the Fed is more focused on trying to work off its book of mortgage-backed securities,” says Haworth. The Fed’s balance sheet of asset holdings grew to just under $9 trillion in early 2022. It’s now been reduced to $7.14 trillion.5 “It seems unlikely the Fed will drop its balance sheet back to the $4 trillion level, as it stood in 2015-16, but given the extent the economy has grown since then, a larger Fed balance sheet may be justified,” says Haworth.
U.S. economy continues to grow
Despite significant Fed monetary tightening, the U.S. economy remains resilient, and it appears that the Fed expects growth to continue. First quarter 2024 annualized Gross Domestic Product (GDP) growth came in slightly lower than expectations, at 1.4%, but second-quarter GDP doubled that pace, expanding at an annualized rate of 2.8%.6 “The consumer is still hanging in there,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. “However, the environment may be getting a little tougher for lower-income consumers.” Notably, FOMC members, in their most recent estimate, anticipate that GDP will expand 2.1% over the year, a slight drop from 2023’s 2.5% GDP growth rate.7
Be sure to consult with your financial professional and review portfolio positioning to determine if changes might be appropriate given your goals, time horizon and feelings toward risk in today’s evolving interest rate environment.
Frequently asked questions
Monetary policy is controlled by a nation’s central bank, which in the United States, is the Federal Reserve (Fed). The Fed’s management of monetary policy can have a significant impact on the shape of the nation’s economy. Congress’ mandate for the Fed is to maintain price stability (manage inflation); promote maximum sustainable employment (low unemployment); and provide for moderate, long-term interest rates. Fed monetary policy influences the cost of many forms of consumer debt such as mortgages, credit cards and automobile loans.
The Fed is the nation’s central bank, and perhaps the most influential financial institution in the world. The central governing board of the Federal Reserve reports to Congress, with the chair of the Federal Reserve appointed by the President. There are also 12 regional federal reserve banks that are set up like private corporations.
The Federal Reserve’s Federal Open Market Committee (FOMC) sets a target interest rate policy for the federal funds rate. This is the rate at which commercial banks borrow and lend excess reserves to other banks on an overnight basis. The fed funds rate is raised or lowered usually to help impact underlying economic conditions. For example, in 2022, as inflation surged, the FOMC began raising interest rates to make borrowing more expensive and slow economic activity. That strategy was designed to ease pricing pressures and reduce the inflation rate. In periods when the economy is slow or in a recession, the Fed tends to lower rates to try to stimulate economic activity and help the economy expand again.
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