The real uncertainty with rate cuts

With interest rate cuts on the horizon, it’s important to focus on what matters

Much has been said recently about when the Fed will start cutting interest rates. But the important question for markets isn’t when rate cuts begin, rather where rates will ultimately settle.

The bout of inflation-fighting interest rate hikes from 2022 into 2023 wreaked havoc on markets, driving down the value of many assets including stocks and bonds. With inflation now falling closer to its long-run target of 2%, investors are eagerly anticipating the day when the Fed will take its foot off the brake and begin cutting rates.

Indeed, the Fed seems poised to drop interest rates soon. While rates have held steady for the past three quarters, current projections from members of the Fed’s FOMC rate-setting committee show three expected cuts by the end of this year. Investors are putting a 50% chance of the first of those cuts coming in June.

A cut in rates would be a welcome development in financial markets, particularly for stock investors. Lower rates mean reduced borrowing costs, which typically boosts both consumer and corporate spending power. This broadly improves the expected outlook for business profits, making stock ownership more appealing.

But what matters more than the timing of the Fed’s initial rate cut is where interest rates eventually settle this cycle. Specifically, it’s most important where rates end up compared to the neutral rate.  

The neutral rate is the theoretical “goldilocks” level of interest rates where unemployment is as low as possible and inflation is at its target level. If factors lead to unemployment climbing to undesirable levels, the Fed seeks to remedy this by lowering rates below the neutral level to accommodate growth and spur hiring. If inflation rises to uncomfortable levels, the Fed raises rates above the neutral level to restrict growth and ease inflation (for more, see Fed 101: back to basics).

The challenge here is that the neutral rate is strictly theoretical and therefore impossible to measure. Moreover, the dynamic nature of the economy means the neutral rate is a constantly-moving target (even in theory!). This makes the Fed’s accommodation or restriction to the economy a challenging and imprecise practice.

So, when Fed Chairman Jerome Powell uses the phrase “sufficiently restrictive” to describe interest rates as of late, that means he believes economic activity has been slowed because rate levels have been above the neutral rate. And, yes, it now appears that the Fed feels the current level of restriction will no longer be needed—cue the cuts. But before popping the champagne, there are important points of uncertainty that must be considered.

To begin, when cuts come, there is no guarantee as to where rates will settle compared to the neutral rate. Inflation has come down markedly in the past two years, but it remains above the Fed’s 2% target. If upward pressure on prices persists, the Fed’s rate cuts could land at a level that is still restrictive (albeit less so than now).

Even if restriction is unnecessary and rates are cut to a neutral level, there is no guarantee as to what the nominal rate of interest will end up being. In the low-inflation low-growth environment of the period prior to the pandemic, most economists pegged the neutral rate at a very low level. The Fed held its policy rate near zero and the economy never grew fast enough to send inflation higher than target.

In the post-pandemic economy, it’s widely believed that the neutral rate is now much higher than in the past. So, cutting rates to neutral would be unlikely to bring back the low levels of rates many of us had become accustomed to prior to COVID.

This matters to investors because interest rates impact borrowing costs, which influence demand, supply, and ultimately the profits of companies whose stocks are traded by investors. Given the uncertainty about the dynamics of the economy, the neutral rate, and interest rate policy, it’s impossible to know exactly where rates will land. But the level of interest rates in the future will have far more of an impact on the economic environment and financial markets than when the first cut in rates occurs.

Alesco Advisors applies an investment philosophy with this type of uncertainty in mind. We construct client portfolios that are intended to weather a variety of market environments, because we know that future economic conditions are impossible to predict. We believe this practice is the best way to give our clients the highest probability of achieving their long-term investment goals.

The content in this blog post is provided for informational purposes only, and should not be construed as personalized investment advice. The data and information used in the preparation of this blog post are obtained from third-party sources believed to be reliable, but Alesco Advisors does not guarantee the accuracy, completeness, or timeliness of the data and information.