THE FEDERAL RESERVE´S INTEREST-RATE CUTS MAY DISSAPOINT INVESTORS / THE ECONOMIST

The Federal Reserve’s interest-rate cuts may disappoint investors

Jerome Powell could still surprise on the hawkish side

Illustration of a silhouette of a person in profile wearing a party hat with "0%" on top, blowing a party horn, against a bright pink background / Illustration: Satoshi Kambayashi

The longed-for moment has at last arrived. 

For two and a half years, ever since America’s Federal Reserve embarked on its fastest series of interest-rate rises since the 1980s, investors had been desperate for any hint of when it would reverse course. 

But by the time Jerome Powell, the central bank’s chair, announced the first such reduction on September 18th, the debate among traders was no longer “whether” but “how much”. 

Weeks beforehand, at an annual gathering of central bankers in Jackson Hole, Wyoming, Mr Powell had already more or less confirmed that a cut was imminent. 

In the event officials plumped for a jumbo-sized chop, of 0.5 percentage points, to between 4.75% and 5%.

After an initial bounce, share prices finished the day slightly below where they started it. 

That might seem odd given how investors have reacted to Mr Powell’s pronouncements over the past couple of years. 

After all, America’s stockmarket has spent much of the time cratering whenever it looked like interest rates would stay higher for longer, and soaring on any suggestion that borrowing costs might soon come down. 

It is not for nothing, though, that “buy the rumour, sell the fact” is such an enduring mantra in financial markets. 

For all that the prospect of rate cuts sets investors’ pulses racing, their actual arrival has often proved disappointing—and not just on the day they are announced.

Consider how share prices have responded to previous loosening cycles. 

Although the three episodes in the 1990s, when Alan Greenspan was at the Fed’s helm, did give the stockmarket successive boosts, this century’s record has been a little drearier. 

Rate reductions in the early 2000s took place during the bursting of the dotcom bubble; those starting in 2007 coincided with the market crash that accompanied the global financial crisis. 

The doveish turn that got under way in 2019 buoyed share prices at first, but the effect was then swamped by the onset of the covid-19 pandemic.

Like so much in finance, rate cuts have a small effect on share prices (in this case a positive one) that is easily obscured by other factors. 

The fillip comes from a reduction in borrowing costs, which allows companies to keep more of their profits and encourages customers to spend more on their products. 

If bond yields also fall, prospective returns on shares become that much more attractive by comparison, providing another boost.

What, then, might be the swamping factors this time? 

One is perennial: that money never gets cheaper in isolation, but because central bankers fear economic weakness and want to stave it off. 

Just now, that seems like less of a concern than normally is the case. 

True, America’s labour market has cooled, which prompted a brief growth scare among shareholders over the summer. 

However, unusually for the end of a tightening cycle, the economy appears to be merely slowing down rather than entering a recession. 

Company profits should therefore be safer than usual as the Fed reduces rates—and so should share prices.

More worrying are the infamous “long and variable lags”, as named by Milton Friedman, between changes in monetary policy and their impact on companies and consumers. 

Counterintuitively, even as the Fed loosens, many borrowers will face steeper interest bills. 

Any firm that issued fixed-rate debt while money was nearly free, which is plenty of them, will eventually need to refinance. 

Since there is little prospect of the Fed returning interest rates close to zero any time soon, debt-servicing costs for such companies will be rising for some time yet. 

Homeowners on fixed-rate mortgages who need to refinance (after moving house, for instance) will be in a similar position. 

As such, rate cuts may energise the economy, and hence the stockmarket, less today than they would have done in the past.

The biggest hint that the Fed’s largesse will disappoint investors in the coming months, though, is the extent to which the market has been anticipating it. 

Before the rate-setting committee met, traders’ central expectation was already for 1.25 percentage points’ worth of cuts before the year is out, followed by another 1.25 next year. 

Such rapid moves have only occurred in the past amid recessions or crises. 

There is plenty of room, in other words, for Mr Powell to surprise on the hawkish side even as he continues to slash rates, which would raise bond yields and make stocks less attractive. 

Rate cuts ought to be good for the stockmarket. 

But not if investors have already pocketed their benefits.