Following the Federal Reserve’s annual economic conference in Jackson Hole, Wyoming, Chairman Jerome Powell said something that much of the financial world has been waiting to hear, “The time has come for policy to adjust.”
Translation: Interest rates are about to start coming down!
Ever since inflation peaked in 2022, the Fed has been on a mission to tame them by slowly rasing the Federal funds rate. Economics 101 says that by doing this, businesses and consumers will pull back and slow down the economy. In turn, this should cause the prices of goods and services to fall – resulting in less demand, lower prices, and reduced inflation.
It’s been a work in progress, but after two years of sticking to this playbook, it seems the Fed’s efforts are paying off. As of July 2024, the Consumer Price Index (CPI) only rose 2.9 percent for the past 12 months. Core CPI, the same index less food and energy (and the indicator used by the Fed), only rose 3.2 percent year over year. Very promising!
Combined with the fact that unemployment numbers are also starting to creep up, analysts are one hundred percent certain that a rate cut is imminent. According to the FedWatch tool from the CME Group, it’s just a question of how much of a rate cut and how many will happen before the end of the year.
As a steward of your household finances, it’s important to understand what is likely to happen to the economy and your personal wealth if and when the Fed does eventually decrease interest rates. Based on past events, here’s what you can expect.
1) Better Loan Rates
The first thing most people will notice is that the cost of borrowing will become cheaper. Usually, when the Fed reduces interest rates, banks follow in tandem for each of their products such as loans and savings accounts. This is welcomed news for people looking to make a big ticket purchase like a home, car, go to college, etc.
For some industries such as the housing market, an interest rate cut could increase demand. Prospective buyers who have wanted to move but were waiting due to the higher interest rates may find it’s a good time to get off the sidelines and take action.
Consumers won’t be the only ones to benefit. Businesses, both small and large, will find it cheaper to finance everything from making short-term payments to long-term expansions. For publicly traded companies, this can help improve their financial health and potentially lead to rising stock prices.
2) Refinancing Opportunities
If you were one of the many Americans who’s purchased a house in the last three years, then there’s a good chance you got stuck with a mortgage carrying an APR of 7 or 8 percent. Thankfully, a Fed rate cut could mean some relief is on the way via refinancing.
Refinancing is replacing when you replace your high-interest-rate loan with a new, lower-rate loan. As a general rule of thumb, when there’s a difference of about 1.0% or more between these two loans, then refinancing should be considered. Doing so could potentially shave a hundred dollars or so off your regular monthly payment.
The same will be true for other fixed-rate arrangements such as auto loans and student loans. Check online periodically to see what’s being offered in your area and then run the numbers to find out how much you might save your budget.
3) Lower APY on Credit
Variable-rate loans (such as credit cards and HELOCs) have always been a double-edged sword. Before the surge of inflation, consumers enjoyed rock-bottom interest rates on everyday purchases and the financing of big projects (like a home renovation). However, ever since the Fed started hiking rates, the variable interest rate on these loans was free to escalate to highs we haven’t experienced in some time.
Luckily, once rates go down, the cost of using these financial products won’t be as bad as they were one or two years ago. In fact, they may even begin to look like attractive options once again to people in need of flexible financing.
4) Increased Job Growth
Between businesses being able to borrow for less and increased consumer demand, the textbook expectation of a Fed rate cut is that the economy should prosper. As businesses borrow money to finance their growth, they will also need to hire more people to do the work.
This can be good for both new and current employees. Recent grads may find it easier to land the job they were after and for a competitive salary. Current employees could change companies in search of more pay or a better career trajectory.
5) Potential for Inflation to Return
As you might guess, reducing the Fed funds rate is not without its consequences. Consider the possibility that as businesses borrow for less and economic activity grows, the demand for goods and services will most likely rise. Hence, there is the danger that inflation could return and start climbing back up again.
This same phenomenon occurred during the late 1970s. After the Fed began prematurely reducing interest rates, inflation shot back up essentially undoing their progress. That led to a few more interest rate hikes until the Fed was absolutely convinced that it was safe to begin lowering them again. Fast forward to today, and this is why the current Fed officials have been very careful to hold rates as high as they have for so long.
6) Risk of a Recession
Even though the general expectation of a rate cut should be economic prosperity, the initial reaction is sometimes the opposite. Over the past 40 years, there have been several instances where the economy entered into an official recession even though interest rates were heading downward.
The reason can be attributed to the lag effect of the data used to make interest rate decisions. By the time the Fed reverses its position, there may have been months or several quarters of economic decline that led the country into recession territory.
Again, keeping monetary policy in check is not an easy task for the Fed. They have to walk a fine line between not cutting rates too soon while also holding out just long enough to keep inflation down.
7) Lower Bank Interest on Your Savings
When the Fed begins cutting interest rates, savers will find that their high-yield savings accounts don’t earn as much interest as they used to. This is because, just like with loans and credit cards, banks also tie their savings account interest rates to the Fed funds rate. Therefore, the more they cut, the less interest you’ll earn.
This can be mitigated by locking into longer-term fixed-interest products (like CDs or bonds) before the Fed makes its announcement. However, as interest rates are further reduced, consumers will need to look to potentially riskier investments like stocks, mutual funds, and ETFs for more attractive returns.
Overall, the best thing you can do no matter what the Fed does (or does not) decide is to manage your own budget. Tracking it using an app such as Buxfer is a good approach because you’ll always have a real-time summary of how you’re progressing. That way if the economy does begin to surge, you’ll be able to take the money you’re saving and seize whatever financial opportunity awaits.
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