This week, the Federal Reserve gathers for a highly anticipated meeting on monetary policy. Nearly three years after announcing a policy shift intent on combating rising inflation, it appears the Fed is finally poised to loosen its restrictive policy stance. The market, meanwhile, is treating the potential reversal due Wednesday afternoon as a foregone conclusion. Here is what investors need to know before the rate decision.

The Coming Shift in Policy

The market’s focus is not on whether the Fed will cut rates on Wednesday but rather on how much. The Fed traditionally shifts the benchmark federal funds rate at a cautiously steady pace, with changes typically occurring in 0.25% increments. The slower pace of change allows for some space between meetings to assess the impact of policy. At times, when the Fed feels like its current policy stance is out of line with the reality on the ground, it can move rates in much larger increments. Examples here would be the rapid cuts during the height of the pandemic lockdowns in 2020 or when it front-loaded rate hikes in 2022 after it became apparent they were late to the inflation fight.

Will the Fed stick to the cautious approach with a 0.25% cut? Or seek to front-load the moves with a larger 0.50% cut? The answer will depend on how the Fed assesses what it refers to as ‘the balance of risks.’ The Federal Reserve has a dual mandate of ensuring price stability and maximum employment. What makes this task so challenging is that the two mandates are effectively at odds with each other. Actions taken to restore price stability during a period of rising inflation tend to damage the labor market. Conversely, actions that can stimulate the labor market are often inflationary. The Fed will shift its policy stance when it feels the downside risk of one of its mandates outweighs the other. It will move aggressively if the risks are materially out of balance.

For most of the time since late 2021, the Fed has viewed inflation as the larger risk facing the economy. That view may have changed recently, as evidenced by recent comments from Fed officials suggesting that the cooling labor market may now be the larger risk. While still low by historical standards, the unemployment rate has increased substantially from 3.4% in April of 2023 to 4.3% as of the July report. Historically, when the unemployment rate rises a little, it ends up rising a lot. Meanwhile, inflation, as measured by the Personally Consumption Expenditures Index (PCE), has declined from over 7% to 2.5%, just above the Fed’s 2% target. 

At the annual Jackson Hole Symposium last month, Jerome Powell suggested, “We do not seek or welcome further cooling in labor market conditions.” Further adding, “the time has come for policy to adjust.”

The Fed is EXTREMELY careful when giving the market clues about its policy intentions, something that is commonly referred to as ‘forward guidance.’ The Fed is well aware that the market will dissect every subtle change in its messaging. Such direct and unambiguous language from Powell sent a very strong signal to the market.

In addition to the rate announcement on Wednesday, the market will be paying close attention to the ‘dot plot.’ This graphic, which the Fed publishes once a quarter, reflects each committee member’s expected path of monetary policy over the next few years. The market recently began to price in a more aggressive easing. At the time of this writing (Tuesday morning - 9/17), the fed fund futures market was pricing in cuts totaling 1.25% by the end of 2024, including a 0.50% cut on Wednesday (9/18). If the median estimate for rate cuts illustrated on the dot plot is materially less than what the market is expecting, we could see some volatility as the market reprices.

Impact on Investors

The impact from a shift in monetary policy will be felt in a variety of ways. In fact, because markets are forward-looking, investors have already felt some of the impact. Since the start of the 3^rd quarter, we’ve seen⁽¹⁾:

1. Declining short-term rates, with the 3-month Treasury yield falling -0.52% to 4.96%.
2. Declining longer-term rates, with the 10-year Treasury yield falling -0.73% to 3.63%.
3. Declining mortgage rates, with the national average 30-year fixed⁽²⁾ falling -0.66% to 6.20%.
4. Strong bond market performance, with the Aggregate Index gaining +6.00%.
5. Strong stock market performance, with the Russell 3000 gaining +3.83%.
6. Particularly strong performance in stocks that have struggled under tight monetary policy, with small-cap value gaining +9.27%.  

While some instruments, such as bank savings rates and money market mutual funds, might not see a rate impact until after the announcement, the list above represents sizable moves for such a short period of time. It’s possible there is more room for the above moves to continue, or perhaps the market has already taken them too far. In the case of the latter, we’d likely see some degree of a reversal following the Fed announcement. The market is forward-looking, and the market is efficient in that prices reflect the best possible prediction of the future. That doesn’t mean the market always gets it perfectly right, however.

Ultimately, the intent of the Fed is to ease its foot off the breaks that have been slowing economic activity and cooling the labor market. To the extent that economic activity picks up, corporate earnings should grow, which should support rising stock prices. While declining yields result in lower expected future returns for bondholders, they are at least compensated via rising bond prices in the present. Savers in cash instruments receive no such benefit. Those that have remained heavily allocated to cash will see their returns dwindle with little to show for it.

1. All data as of 9/16/2024. Source FRED and Morningstar Direct. Small Cap value performance illustrated by the SPDR S&P 600 Small Cap Value ETF (SLYV).
2. Source: Freddie Mac Primary Mortgage Market Survey via the FRED database.

Source: MarketWatch

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