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In a move that was widely anticipated, the Federal Reserve has cut the federal funds rate by 0.25 percentage points, to a new target range of 4.50% to 4.75%.
Thursday’s rate cut comes after the Fed cut interest rates for the first time in four years back in September, a positive sign the central bank is confident it has inflation under control.
“In considering additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook and the balance of risks,” the Fed said in its statement on Thursday.
Why Does the Fed Funds Interest Rate Matter?
The fed funds rate is typically considered the most important interest rate for Americans. While the Federal Reserve does not set interest rates directly, it does set the fed funds rate, which is the rate banks and other financial institutions charge each other for overnight loans. These short-term loans allow banks to maintain minimum capital levels required by law.
In addition, banks use the fed funds rate as a baseline to determine the interest rates they charge on credit cards, mortgages, auto loans and other types of debt. Banks also consider the fed funds rate when setting the interest rates they pay on deposits and certificates of deposit (CDs). When the Federal Reserve cuts the fed funds rate, bank rates tend to fall as well.
The Fed uses the fed funds rate as a tool to achieve its dual mandate of maximizing employment and maintaining stable prices. Lower interest rates increase economic activity, which in turn leads to inflation and increased prices. Higher interest rates cool down prices but slow down the economy. The Fed’s challenge is to delicately balance the economy by raising or lowering interest rates at the right time.
In 2024, the Federal Reserve is not cutting interest rates to stimulate the economy, but rather to normalize rates. A combination of pent-up consumer demand, supply chain disruptions and a tight labor market sent inflation soaring to 40-year highs in 2022. In response, the Fed aggressively raised interest rates in 2022 and early 2023 to bring down inflation. The fed funds target range peaked at between 5.25% and 5.50% in July 2023, its highest level since 2001.
Navigating a Soft Landing
Up to this point, the Federal Reserve has achieved a “soft landing” for the economy by bringing down inflation without tipping the economy into a recession. The U.S. economy has continued to grow in the past couple of years, even with interest rates at historically high levels.
In October, the Labor Department reported the consumer price index (CPI), a popular measure of US inflation, rose 2.40% year-over-year in September. CPI inflation was down from a 2.50% annual gain in August and well below its cyclical peak of 9.10% in June 2022. The Commerce Department recently reported the core personal consumption expenditures (PCE) price index was up 2.70% in September. Core PCE, which excludes volatile food and energy prices, is the Federal Reserve’s preferred inflation measure. The Fed’s long-term target for core PCE inflation is 2%.
Economy Slowing?
The latest labor market data suggests the recent Federal Reserve rate cuts may be coming just in time. The Labor Department reported the U.S. economy added just 12,000 jobs in October, well below economist expectations of 100,000 new jobs. U.S. wages were up 4% year-over-year in October. Fortunately, the unemployment rate remained unchanged at 4.10%.
In addition to a softening labor market, U.S. gross domestic product (GDP) growth dropped to just 2.80% in the third quarter, down from 3% in the second quarter. GDP is a measure of the combined value of all goods and services produced in the economy over a set period of time and is a key indicator of the economy’s overall health.
“We continue to be confident that, with an appropriate calibration of our policy stance, strength in the economy and the labor market can be maintained with inflation moving sustainably down to 2%,” Fed Chair Jerome Powell said in his post-meeting press conference on Thursday.
Powell also noted that the recent election results will have no immediate impact on the Fed’s near-term policy outlook. The Federal Reserve has historically operated independently of the executive branch.
Balance Sheet Runoff
In addition to interest rate cuts, one tool the Federal Reserve uses to support the economy during periods of crisis is quantitative easing (QE). QE involves the Fed buying U.S. Treasury bonds and agency mortgage-backed securities (MBS) from banks to inject capital into the financial system. During the Covid-19 pandemic in 2020, the Federal Reserve began an aggressive QE program that lasted until 2022. The Federal Reserve’s balance sheet expanded from roughly $4 trillion prior to the pandemic to a 2022 peak of around $9 trillion.
Starting in 2022, the Federal Reserve began allowing a small amount of MBS and Treasuries to mature each month without reinvesting in more securities. As a result, the Fed has been passively shrinking its asset holdings at a measured pace.
On Thursday, the Fed said it will continue to allow up to $25 billion in Treasury securities and $35 billion in MBS to mature and roll off its more than $7 trillion balance sheet per month.
Economic Outlook
The Federal Reserve is in the difficult position of normalizing interest rates at exactly the right pace. If it cuts rates too slowly, it could risk tipping the economy into a recession. If it cuts interest rates too quickly, the Fed could trigger a potentially disastrous rebound in inflation.
The New York Fed’s recession probability model estimates there is a 57% chance of a U.S. recession in the next 12 months, reflecting the Fed’s precarious position.
Federal Reserve economists were anticipating a slowdown for the U.S. economy even prior to the recently released third-quarter GDP growth estimate. The Fed currently projects GDP growth of 2%, core PCE inflation of 2.20% and a US unemployment rate of 4.40% in 2025.
The stock market reacted very positively to Donald Trump’s election victory this week, with the S&P 500 reaching record highs on the day after Election Day. The S&P 500 reflects the collective stock prices of roughly 500 publicly traded U.S. companies, and it is typically considered the best measure of the stock market.
S&P 500 companies are on track to report 5.10% earnings growth in the third quarter, the index’s fifth consecutive quarter of positive earnings growth. Analysts are expecting earnings growth to accelerate to 12.70% in the fourth quarter.
The S&P 500 was trading higher on Thursday following the Fed announcement.
What’s Next?
In September, Federal Reserve officials projected two additional 0.25 percentage point rate cuts in 2024, suggesting another interest rate cut is likely at the Fed’s next meeting that concludes on December 18.
According to CME Group, a derivatives marketplace, markets are currently pricing in a 75.40% chance the Fed will cut interest rates again in December. Investors and central bankers have roughly six weeks of economic data to monitor between now and the next Fed meeting that could have a significant impact on monetary policy.
Jamie Cox, managing partner for Harris Financial Group, says Americans can expect interest rates to continue to steadily drop in 2025.
“The balance of risks gives the Fed ample room to lower the Fed Funds rate well into 2025. Markets should not expect supersized rate cuts unless the economy turns south and [that] doesn’t look at all likely for a while,” Cox says.
The October PCE inflation reading on November 27 will hopefully confirm inflation is still trending steadily lower. Fed officials will also be watching the November U.S. jobs report on December 6 for an update on how interest rate cuts are impacting the labor market.
Election Impacts
Trump’s election victory may have a direct impact on the Federal Reserve in 2025, particularly Powell. Trump appointed Powell to his position back in 2018, but he has been highly critical of him in recent years. In 2020, Trump said he had the “right to remove [Powell] as chairman” and noted that “he has, so far, made a lot of bad decisions.”
The Federal Reserve is independent from the executive office, making it difficult for the president to remove a Fed chair who has not broken the law. Powell’s term as Chair of the Board of Governors is not up until May 15, 2026 and his term as a member of the Board doesn’t end until January 31, 2028.
In October, Trump said the president should be allowed to publicly share an opinion on interest rates.
“I don’t think I should be allowed to order it, but I think I have the right to put in comments as to whether the interest rates should go up or down,” Trump said.
On Thursday, when a reporter asked Powell if he would resign if Trump asks him to, he simply replied “no,” adding that the president removing the Fed chair is “not permitted by the law.”
Trump’s victory could make the Fed’s job more difficult in other ways as well. In June, 16 Nobel Prize-winning economists signed a letter warning Trump’s proposed tariffs on global imports could lead to a resurgence in inflation. If American companies must pay higher prices for imported materials and components, many may choose to pass those higher costs on to consumers by raising prices.