The U.S. Federal Reserve cut interest rates this past week, joining many other major developed central banks who have started to reduce interest rates in recent months. Another important development was the notable decline in Canada’s inflation rate, with August’s headline inflation reaching the Bank of Canada’s target of 2% for the first time since 2021. Below, we take a closer look at the Fed decision and explore how lower interest rates may impact the economy, and what they may mean for the financial market outlook.
The Fed opted to cut interest rates by a half of one percent - larger than the quarter percent reductions seen from other central banks. Fed Chairman Jerome Powell characterized the move as one that was needed to “recalibrate” the bank’s approach given the fall in inflation and increase in unemployment over the past year. In contrast to the past few years, when the Fed felt the balance of risks was skewed more heavily towards inflation, it noted the risks between inflation and employment are now “roughly in balance”. The Fed telegraphed that additional rate cuts are likely through the remainder of the year, but Mr. Powell emphasized they are meant to preserve and extend what it regards as a reasonably healthy economy.
Lower interest rates translate into reduced borrowing costs for businesses and consumers. As with interest rate increases, there is often a lagged effect from interest rate cuts, with the speed at which any relief is felt varying and depending on the circumstances of borrowers. On the business front, small businesses often hold floating-rate loans, which adjust quickly to lower interest rates, while larger companies often hold longer-term fixed rate debt that takes longer to reprice.
Consumers may also feel the impact to varying degrees. Credit card users should see some early benefit given the variable rate nature of credit card debt. Meanwhile, the impact to mortgages may be more mixed. For consumers looking to buy a new home, they may be encouraged by the decline in mortgage rates though they may also be tempted to wait given the Bank of Canada and U.S. Federal Reserve have telegraphed the potential for even lower rates in the months to come. Meanwhile, for Canadian homeowners that are facing mortgage renewals, the reduction in rates this year may simply reduce the headwind that some Canadian mortgage holders are facing given many will have to renew at borrowing costs that are still substantially higher than the ultra-low rates they may have locked in years ago.
While global equity markets have responded favourably to the initial round of interest rate cuts from central banks, history suggests some caution is warranted. There have undoubtedly been some periods of strong equity markets gains following the beginning of an easing cycle. Likewise, there have also been some notably weak periods following the first interest rate cut, typically reflecting a deteriorating economic and corporate earnings backdrop. Overall, the range of historical outcomes for equity markets has been wider than normal after the first interest rate cut.
We view the path forward with cautious optimism, acknowledging that lower interest rates will eventually lead to easier financial conditions. Nevertheless, as with hikes, the cuts will take time to provide some relief to consumers, businesses, and the economy. In the meantime, we are mindful of the lesson that history has taught us: the start of interest rate cuts can either extend the economic cycle or mark an important turning point. We will be watching closely for signs of either scenario unfolding.
I am pleased to share the latest investment strategy report from RBC Wealth Management: Global Insight Weekly.
Highlights:
Big bang
After biding its time, the Fed finally kicked off its monetary easing cycle with a strong start out of the rate cut gates. While investors may harbor some concerns the Fed is getting ahead of itself and that more aggressive cuts could reignite inflationary pressures, we highlight why we are encouraged by the Fed’s proactive move.
Regional developments: Headline Canadian CPI growth falls to 2.0% target for first time since 2021; Equity rotation continues as Magnificent 7 trade loses steam; Bank of England in wait and see mode; Asian equities rally after Fed rate cut.
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