WEALTH AND WISDOM: FINANCE 101
Fifty basis points down: what the Fed’s rate cut means
The Fed cuts rates to maintain a stable economy, but the market should remain alert.
The Fed cuts rates to maintain a stable economy, but the market should remain alert.
For the first time in four years, the Federal Reserve cut interest rates last month by 50 basis points (0.5%) to 4.75–5.0%. This move is what’s known as an expansionary monetary policy. As the name suggests, this policy stimulates growth and demand. However, there’s speculation on the intention of such a bold approach and whether this choice potentially signals deeper economic issues.
Under this policy, the lowered interest rate results in a decrease in the cost of borrowing money, which encourages spending and stimulates the economy. This will lead to an increase in supply and demand, creating jobs and decreasing the unemployment rate. Conversely, rate cuts tend to hurt lenders and savers, so hopefully, you invested your money into a certificate of deposit before the Fed cut rates.
The Fed released a statement stating that “the progress on inflation and the balance of risks” influenced their decision. Their goal is to return inflation to 2% and maximize employment.
To understand the effects of the Fed’s policies, you must understand the business cycle — a cycle of fluctuations that explain the expansion and contraction in economic activity over time. Think of a recession, a decline in economic activity, as going down a hill, and expansion, as going up the hill. This can be caused by variables such as high interest rates. Changes in monetary policy influence the business cycle and its path, so when the Fed expects a recession or worsening conditions, it cuts rates to soften the blow.
That’s why this specific cut is interesting. The Fed cut rates by 50 basis points in early 2001, 2007 and 2020, which makes this cut unusual because there is no obvious financial crisis. Still, this move could signal that the Fed policymakers are more worried than they let on.
The Fed’s meeting minutes say that the cut should “not be interpreted as evidence of a less favorable economic outlook.” But, it’s worthwhile to note that if the Fed cuts rates, the standard reduction is 25 basis points, which makes this a bolder move.
While this move isn’t necessarily a caution to an incoming recession, the market should still stay vigilant. Currently, the unemployment rate in the United States is 4.1%. This rate isn’t historically abnormal and can be considered “healthy,” but it has grown as the unemployment rate was 3.6% back in March. The Fed is taking the slowing labor market seriously, hence the aggressive cut. However, inflation still stands at 2.4%, which is above the 2% target. Fed Chair Jerome Powell said that while inflation moves toward the goal, this is not “mission accomplished.”
It’s essential to remain alert. If inflation starts rising, this rate cut would be considered premature. Furthermore, if the Fed continues to cut rates too low too quickly, policymakers can contribute to asset bubbles, which can lead to recession. Because borrowing costs would be lower, people invest in assets, and as more people invest in certain assets, they drive higher prices. If these price increases aren’t justified, the bubble bursts as demand slows and prices fall quickly.
According to Fed governor Christopher J. Waller, the Fed could’ve lowered rates by 25 basis points if data continued to look “fine,” allowing policymakers to hold rates steady.
In any case, it seems that the key reason the Fed cut rates is to support employment and focus on the job market, which is cooling down. Powell said that “the upside risks to inflation have diminished, and the downside risks to employment have increased.”
It’s also important to note that despite what some believe, Powell makes decisions independent of political considerations.
“This is my fourth presidential election at the Fed, and it’s always the same … Our job is to support the economy on behalf of the American people,” Powell said. “It is something we all take very, very seriously. We don’t put up any other filters.”
While the Fed’s policy intends to lower the unemployment rate and decrease the cost of borrowing, economists say that the effects won’t be instantaneous and could take six to 12 months. The rate cut can be seen as a signal that the process has begun.
As of now, the Fed will most likely continue to cut rates. Goldman Sachs analysts predict three consecutive 25 basis point cuts in September, November and December. However, Fed policymakers must remain cautious and not lower rates too much too quickly to avoid recession.
The Fed’s aggressive 50 basis point rate cut is a unique approach to support the job market. The goal is to keep the economy from recession rather than implying a potential recession. However, if inflation rises and there is economic decline, the Feds must pivot by cutting interest rates even more aggressively. Despite predictions, there is some uncertainty regarding what the Fed will do next as it makes decisions based on available economic data.
Janette Fu is a junior writing about her thoughts on recent financial, economic and business news. Her column “Wealth & Wisdom: Finance 101” runs every other Friday.
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