Fed Interest Rate Decision: Half-Hearted Change of Course or Soft Landing?

The U.S. Federal Reserve is on the verge of lowering short-term U.S. borrowing costs. This decision marks a pivotal moment, as it could alleviate the financial burdens on consumers after two and a half years of a persistent struggle against high inflation. Following a series of aggressive rate hikes totaling 5.25 percentage points between March 2022 and July 2023, the Fed is now expected to choose between a reduction of its benchmark interest rate by a quarter-point to 5.00%-5.25% or even by half a point to 4.75%-5.00% to address growing concerns about a cooling labor market. Regardless of whether the central bank opts for a large or small cut, it is widely anticipated that it will further reduce rates to around 4.5% or even 4% by the end of the year, with additional cuts in 2025. Fed officials, however, have made it clear that they do not expect the benchmark rate to return to the sub-2% levels that prevailed for more than a decade before 2022. Thus, the era of low mortgage rates, often below 4%, is effectively over for now. Nevertheless, lower benchmark rates should lead to more favorable borrowing costs for most types of credit, while wages on average rise faster than prices as inflation has significantly cooled. However, daily purchases serve as a reminder that today's dollar no longer holds the same value it did a few years ago. The Fed's aggressive rate hikes, which only began after inflation had already surged, were initially expected to cause an economic slowdown accompanied by job losses. Instead, the economy has so far managed to avoid a recession, and inflation measured by the Consumer Price Index fell from a peak of over 9% in mid-2022 to 2.5% currently. The unemployment rate, recently risen to 4.2%, remains historically low. With the rate cut, the Fed aims to maintain this state of affairs. Already, hiring and wage growth have slowed, the number of job vacancies per worker has decreased, the duration of job searches has lengthened, and more workers are taking part-time jobs, although they would prefer full-time employment. Lower interest rates are intended to mitigate these trends through more affordable credit options for businesses and households, thereby spurring consumption. Whether the Fed can calibrate its rate cuts to achieve a so-called "soft landing" remains one of the most significant questions regarding how its actions will affect Americans' daily lives. "The challenge is that soft landings are rare and often as much about luck as skill," says Diane Swonk of KPMG, who expects the Fed's benchmark rate to be at 4.25%-4.50% by year's end. "We have never achieved a soft landing after an actual inflationary period." Borrowing costs for home loans, credit cards, auto loans, and student loans have risen sharply as the Fed increased its benchmark rate. Some of these rates, particularly mortgages, have already fallen as the Fed signaled its intention to cut rates. For instance, the average rate for 30-year fixed mortgages from Freddie Mac recently dropped to 6.20% from a peak of nearly 8% last October. The stock market's reaction to the Fed's rate cut is less predictable, as it depends on whether the move is seen as a sign of a secured soft landing or an indication that the Fed is behind the curve and could cause the economy to crash. In the long run, lower interest rates tend to boost stock markets, as investors are more willing to take on risk when yields on safe assets like government bonds decline. The performance of the housing market, however, remains comparable to levels observed during the housing bubble before the 2007-2009 financial crisis. A Fed rate cut will not significantly change this in the short term, although lower borrowing costs should ultimately stimulate the housing market. According to Kathy Bostjancic of Nationwide, there is even the possibility that rising supply in some areas could lead to a slight decline in property prices.