For the last two years the Federal Reserve has been on a cycle of raising the federal funds rate, also known as tightening fiscal policy, in order to curb inflation. The Fed’s goal is to curb inflation while avoiding a recession. As we have discussed in the past, raising interest rates increases the cost of borrowing and discourages spending for both consumption and investment, which slows the economy. This week the federal reserve declared victory over inflation by reversing course and lowering the Federal Funds rates by ½%. While it may seem like a small move, the shift in position is important. With this move the Federal Reserve signals that inflation is no longer as big a risk as a recession.
The current tightening cycle began in March of 2022 when the Federal Reserve raised interest rates from 0.25% to 0.5%. From that initial move the Federal Reserve continued to raise interest rates very aggressively by historical standards ending at 5.5% federal funds rate in July of 2023, a level not seen for 20 years. The Fed Funds rate has stayed at 5.5% for the past year, slowing the economy and driving inflation down.
August’s 2.5% CPI inflation reading gave the Federal Reserve the confidence to ‘ease up on the brakes’ so to speak by dropping rates. Economists are mixed on whether this is a wise move. The economy is still strong so there is a risk that the Federal Reserve acted too soon, and we could see a resurgence of inflation.
However, for now the stock market reacted positively, rising 1.29% for the week. Lower interest rates are supportive for assets of all types, including stocks, bonds, real estate, gold, and commodities. Overall, this should be good news since the headwinds of high interest rates are reduced which helps the overall economy.
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