Seeking to lower inflation, the Federal Reserve began raising borrowing costs in March 2022 and held them at the highest level in more than two decades over the past year. Recent data showing price increases cascading towards normal levels has been much more encouraging than earlier this year. Simultaneously, the unemployment rate has gradually risen amid a softening in the broader labor market. Those two trends prompted the Fed to reverse course and begin lowering interest rates this month, a long-awaited pivot and major economic event.
Reducing inflation has been a bumpy road. Monthly data during the first quarter of this year were consistently above expectations, temporarily stalling the progress made in preceding quarters.
More recently, though, inflation has cooled to the slowest pace since 2021 on the back of a long-awaited slowdown in housing costs. The annual inflation rate for the Consumer Price Index (CPI) in August dropped to 2.5%, having peaked at 9.1% in June 2022.
While price increases have slowed, unemployment has risen in recent months and is now near the highest level since 2021. So far this year, the unemployment rate has crept up from 3.7% to 4.2%, an increase seldom seen outside recessions. Historically, when unemployment moves this much higher, it tends to keep going up. Simultaneously, annual wage growth has steadily declined from 5.9% in March 2022 to 3.8% in August. The labor market has clearly weakened.
The Fed, by law, has a dual mandate—maintaining stable prices and maximizing employment. The goal for low and stable inflation of 2% per year is most consistent with achievement of both parts of the dual mandate. However, there is no specific fixed goal for employment, as the maximum level of employment can be influenced by many factors and may change over time.
With inflation receding and nearing the Fed’s target and the labor market quickly weakening, it appears that higher interest rates have done their work diminishing demand. Enough progress has been made so that the Fed feels comfortable pivoting to a return to the neutral interest rate, a lower rate at which monetary policy is neither stimulating nor restricting economic growth. The biggest risk to cutting rates is that inflation may not be defeated. Therefore, while the Fed anticipates a steady progression of rate cuts throughout the next two years, they will closely monitor economic conditions to determine the size and cadence of future reductions.
Investors, though, have seen enough positive economic data to draw their own conclusions. With the recent half percentage-point cut, the Federal Funds interest rate is presently in a range of 4.75% to 5.00%. Markets are currently pricing in a rate of 4.30% at year-end, along with further declines to 2.84% in December 2025. Those levels are lower than the Feds current projections.
While the Fed has begun to cut rates, it remains uncertain how low they will ultimately go. With the annual CPI inflation rate at 2.5% and short-term interest rates at 4.9%, the real interest rate (or spread between the two) is 2.4%. The average of this real rate has been 1.0% since the late 1950s. As inflation wanes, there is a greater rationale for even lower interest rates. The difficult part is determining when lower rates become too stimulative, enabling the next inflationary cycle.
Lower interest rates are clearly beneficial on many levels. Consumers spending less on interest payments have money freed up to spend elsewhere and more reasons to take on additional debt for big ticket items such as houses and vehicles. Businesses experience many of the same benefits and may also be more inclined to expand operations and create new jobs. Stock prices will also benefit in numerous ways: lower borrowing costs for companies can translate to higher earnings, price/earnings ratios are generally higher when interest rates are lower, money market and bond investments become less attractive relative to stocks, etc.
The Fed changing course from constraining the economy to stimulating growth is an important milestone. History has shown that the benefits can last for years. While it is premature to make that determination at this time, it is nonetheless a positive event for investors.
