We have been hearing a lot about the Fed Rate and rate cuts and rate hikes. The Federal Reserve is most probably cutting interest rates in the coming months. How will this impact
- The stock market
- The Housing Market
This article discusses the fundamentals of the matter, in short, I will try to ‘Simply Explain’ the facts of the matter.
We will discuss:
- What is the Federal Reserve?
- Which interest rate are we talking about here?
- What is the Federal Reserve Rate?
- How does the Federal Reserve Rate work?
- Impact of the Federal Reserve Rate on the housing market and stocks?
Read about:
Table of Contents
Short intro on Federal Reserve and Fed Rates
The Federal Reserve Rate is the target interest rate set by the Federal Reserve (Central Bank in the USA) at which the banks and other depository institutions like credit unions, lend their extra reserve balances to one another, overnight.
(whereas the discount rate is the interest rate that Federal Reserve Banks charge when they make collateralized loans—usually overnight—to depository institutions).
For instance, currently, the Fed Rate is 5.33% (on the day of the article). So, banks will lend loans to one another at this target rate only.
The Federal Open Market Committee (FOMC), updates and sets the Federal Reserve rate 8 times each year.
How does the Federal Reserve Rate work?
To understand the upcoming impacts of the Fed Rate Cuts in 2024 and 2025 on the economy, we should have a general understanding of how the Fed Rates work.
The Fed Rates is one of the tools that the Federal Reserve uses to keep the economy stable. It has primarily two goals(dual mandate):
- To keep the inflation stable (around 2% which was set as a target rate in 2011 by Fed Reserve)
- To keep the labour market strong, i.e. the unemployment rate is in control.
When inflation is high: When inflation is high, the Federal Reserve (Fed) increases the federal funds rate, which is the interest rate at which banks lend money to each other overnight.
As a result, the interest rates on loans from banks to consumers and businesses also rise. This discourages borrowing, as the cost of taking out loans becomes more expensive.
With less borrowing, there is a reduction in the money supply available in the economy, leading to decreased spending.
As a result, the demand for goods and services falls, which in turn helps to reduce inflation.
When the labor market weakens: When spending decreases significantly due to higher interest rates, demand for goods and services falls. This can lead businesses to reduce production, which may result in fewer jobs and a weakening labor market.
When economic activity slows down and the labor market weakens, the Federal Reserve may respond by lowering the federal funds rate. By reducing the rate, borrowing becomes cheaper, encouraging individuals and businesses to borrow more. This increase in borrowing injects more money into the economy, stimulating spending and economic activity.
Other data that factor into Fed monetary policy decisions, include
- gross domestic product (GDP)
- consumer spending and industrial production
- major events like a financial crisis
- a global pandemic or a massive terrorist attack.
The current scenario
Post Covid inflation was at an all-time high.
Source: Trading Economics
This has been driven, at least in part, by supply chain issues, a housing crisis, pent-up consumer demand and economic stimulus from the pandemic.
Post 2022, the Federal Reserve made a series of rate increases to tame inflation.
The Federal Reserve made a series of rate increases from a range of 0.25% to 0.50% in March 2022 to 5.25% to 5.50% in July 2023.
Source: Forbes.com
Notice that the Federal Reserve typically represents the federal funds rate as a range. For example, instead of setting a specific rate, the Fed might set a target range, such as 5.25% to 5.50%. This allows for some flexibility in how the rate is implemented in the market.
Basis Points: The change in the rates is represented in basis points. 1 basis point is equal to 0.01%. Hence, a 25 basis point increase means an increase of 0.25%.
Due to these consecutive rate increases, the inflation got checked with the current inflation rate as 2.9% recorded in July 2024. This is very close to the target rate of 2% .
Source: Y-Charts
Contrary to this, the labour market weakened and unemployment rose. In fact, the current unemployment rate recorded in July 2024 was 4.3% which rose from 3.5% in July 2022.
Source: https://www.statista.com/statistics/273909/seasonally-adjusted-monthly-unemployment-rate-in-the-us/
Covid—>Supply chain issues, economic stimulus, housing crisis—–> Inflation rose—->Federal Reserve made a series of rate increases—–>Inflation is contained from as high a 9% in 2022 to 2.9% in July 2024—>Unemployment rose—–> Hence now what?
Hence, now that the inflation rate is under control and the labor market is weakening on the other side, it is expected that the Fed will start cutting the Fed Rates to satisfy their dual mandate- keeping prices stable and maximizing employment.
It will cut interest rates, injecting funds in the economy, increase spending and strengthen the labour market.
Impact of Fed Rates
Following the Fed’s July 31 meeting, its fifth gathering of the year, Chairman Jerome Powell held steady once again, announcing no change in interest rates.
However, the Fed has signaled that it’s likely to cut rates once this year, with three more meetings remaining to do so (in September, November and December).
Impact on Housing Market:
The rate increases by the Fed throughout 2022 till 2024 have slowed the housing market. The reason for this is that borrowing money has become costlier.
Also, the cost of houses soared high during this period.
Source: Trading Economics
The anticipated Fed rate cuts is likely to impact the housing market and the mortgage rates. However, there is no direct correlation between the Fed Interest Rates and the housing market and the mortgage rates.
Fed rates do affect the savings account and CD rates directly.
The Fed rates do impact the housing market, as they define the sentiments of the buyers and sellers. In 2022 when the Fed bumped rates seven times a year which saw mortgage rates jump from 3.4 percent in January to 7.12 percent in October. In 2023, mortgage rates went higher still, briefly touching 8 percent.
One correlation between the Fed Funds Rate and the housing market can be seen by comparing the mortgage rates with the Fed Funds Rate over a period of time.
In fact you could see data for the past 30 years in the comparison graph. The blue line represents the Mortgage rate whereas the grey line represent the Fed Funds Interest rate.
You can find that both the graphs move through their troughs and crests in a similar fashion.
Hence, the Fed rate cuts are likely to influence the housing market mortgage rates.
Mortgage rates compared to the Fed Rates
Source: Trading Economics
Another correlation can be found by comparing another metric called Housing Affordability Index (HAI) with the Fed Funds Rate.
The HAI is the is the National Association of Realtors’ (NAR) index or metric, in which higher scores indicate more affordable housing.
Source: https://www.nar.realtor/research-and-statistics/housing-statistics/housing-affordability-index
Check the comparison below.
Source : Federal Reserve Bank of Richmond
So by now we know that the Fed Funds Rate does not have a direct correlation with the housing market. However, the sentiments of the market after a rate cut or increase
might push the mortgage rates lower and hence give a push to the housing market.
Although as I said, keep in mind that the mortgage rates are not directly correlated to the Fed Funds Rates. They depend on the Treasury Yields.
But the subsequent question comes as:
When the mortgage interest goes down (lets say with Fed Rate Cuts), will the prices of houses go up, since now the demand of houses might rise?
The answer is a Yes and a No.
No, because the price of houses are already soaring high and people suffer with affordability issues. People are not able to afford houses with the current prices. Hence, a nominal decline in the mortgage rate will not affect the demand of the houses to rise and hence its prices.
However, if a substantial reduction happens in the mortgage rates then, the demand may rise and hence increase the prices.
But we also need to keep in mind that housing prices do keep on moving up with time.
Impact on stock prices
Generally speaking Fed Interest Rate are inversely related to the stock prices.
Hence, when Fed Rates increase, stock prices fall and vice versa.
But this rise or fall of the stock market is not in a straight line. But overall the impacts follow the principle spoken about.
The reason is-when interest rates rise, it is more costlier for companies and businesses to borrow money from the banks. Hence, they have less capital and less cash flow stability, which typically puts pressure on the stock prices.
However, some sectors are directly related to the Fed Rates. Financial sector which involves banks and other depository institutions like credit union benefit from interest hikes.
This is because, when interest rate rises, banks can charge more from their customers and hence make more money.
If we check the graphs of S&P 500 compared to the Fed Funds Rate for the past 10 years, we can see a correlation.
Of course there are other factors that impact the stock market like the geopolitical scenario at the time, major setbacks like Covid, etc.
In fact, generally the impacts are quicker as compared to impacts on other parts of the economy-housing, bonds, etc.
Source: Investopedia
Let us check the data taken from Schroders, which tabulates 22 past US Federal Reserve Rate cutting cycles, since 1928 until 2019.
It also presents the US stock market growth or decline in the following 12 months post the first rate cut.
The green ones depict a growth in the stock market. We can see that in these 22 cycles the stock market rose 18 times.
The average return seen was 11%.
Add to it the fact that in 16 of these 22 cycles, the economy was either in a recession or entered into one.
Source: Schroders
Another data I have picked up from ‘A Wealth of Common Sense’ blog. I nice one that I do follow for market insights.
My fellow YouTuber ClearValue Tax has also correctly referenced this data in one of his videos.
It depicts the S&P 500 returns after 1 year, 3 years and 5 years following the first rate cuts in the years 1970-2019.
Source: A wealth of common sense
You can observe that in the five years following a rate cut, the S&P 500 has consistently risen, with an average return of nearly 84%.
The three-year period after the first rate cut has generally shown positive returns, with the exceptions of 1971, 2001, and 2007, when the S&P 500 experienced negative returns.
The following year has also generally seen positive returns for the S&P 500, with the exceptions of 1973, 1981, 2001, and 2007.
Hence all these data points that we referred to, depict that the stock market has mostly seen positive growth after a rate cut from the Federal Reserve.
However, more than the rate cut, the reason for the rate cut is more important.
I would say from my observations that when the Fed Rate cut happens to combat a recession then the stock market can be unpredictable or can give negative returns.
But when it happens to stimulate the economy and when the inflation is under control, then the stock market is most likely to give positive returns.
Anyway, in the long term horizon like 5 years, we can expect decent returns.
