Will the Fed finally cut rates? How will the stock market be affected?

With inflation steadily rising over the past few months, it seemed unlikely that the Federal Reserve System (Fed) would cut interest rates, as that could worsen the inflation problem.

However, incoming data and trends are painting a different picture, with inflation showing signs of cooling off. While an interest rate cut in June 2023 is highly unlikely, a Federal Funds Rate cut in September seems imminent.

What Is the Federal Funds Rate and How Does It Work?

The Federal Funds Rate is a critical tool used by the Federal Reserve System to manage the economy.

At the top of the Federal Reserve System is the Federal Open Market Committee (FOMC), consisting of twelve members who meet eight times a year to, among other things, decide on adjustments to the interest rate, known as the Federal Funds Rate.

When the Fed cuts interest rates, borrowing costs decrease, encouraging businesses to take out loans to hire more people and expand production, stimulating the economy in the short term.

However, as purchasing power increases, this often leads to inflation.
Conversely, raising interest rates increases borrowing costs, discouraging loans and economic expansion, thereby helping to control inflation.

This mechanism also impacts the stock market. Lower interest rates generally lead to more funds flowing into the stock market, as people borrow money to invest in stocks, causing stock prices to rise.

What to Expect of the Federal Funds Rate in the Near Future

Since the FOMC meeting in July 2023, the Fed has maintained the interest rate at 5.25%-5.5%. Since then, further disinflation has been observed, and the latest Consumer Price Index (CPI) data indicates that inflation is not accelerating.

This development opens the possibility for the Fed to cut interest rates in September and potentially later in the year, likely by a magnitude of 25 basis points (0.25%).

Vishwanath Tirupattur, Chief Fixed Income Strategist at Morgan Stanley, shared his insights on the future of the Federal Funds Rate.

"There is a good case to be made that between now and the end of the year, we will see this deceleration (of inflation) happen. There will be data coming in, and we believe that there will be more Fed cuts coming. We continue to think there will be three cuts coming this year, starting in September," says Tirupattur.

Comparatively, other central banks are also navigating their interest rate policies in response to changing inflation dynamics.

In the Eurozone, inflation has now fallen close to the European Central Bank's (ECB) target figure of 2%, prompting investors to believe there is room for the ECB to cut its benchmark deposit rate by 0.25%, bringing it down from the current 4%.

While some central banks have already moved to cut borrowing costs, the US Federal Reserve and the Bank of England have yet to make similar moves.

The precedent set by these central banks hints towards the possibility of a Federal Funds Rate cut.

Philip Lane, the ECB's Chief Economist, highlighted the impact of the war between Russia and Ukraine on Europe's inflation rates.

He noted that the significant economic disruptions caused by the conflict have led to a faster decline in inflation in Europe compared to other regions.

When asked about the potential rate cuts, Lane remarked, "Central bankers aspire to be as boring and I would hope central bankers aspire to have as little ego as possible," underscoring the pragmatic approach taken by the ECB in its monetary policy decisions, and his hope for the Fed to follow suit.

How Will the Rate Cut Expectation Impact the Stock Market?

The anticipation of an interest rate cut by the Fed typically leads to increased activity in the stock market.

Lower borrowing costs make it easier for businesses to expand and for investors to borrow funds for stock investments, driving stock prices up.

If the Fed proceeds with the expected rate cuts, we can anticipate a positive reaction from the stock market, with potential increases in stock prices and market activity.

The possibility of an interest rate cut by the Fed later this year has significant implications for both the economy and the stock market.

With inflation showing signs of cooling off, a rate cut could provide a boost to the economy and drive stock prices higher.

Investors and businesses alike are closely watching the Fed's next moves, anticipating the potential benefits of lower borrowing costs and increased economic activity.