This week the Federal Reserve’s interest rate-setting body, the Federal Open Market Committee (FOMC), will deliberate on the path of monetary policy. While no changes to the benchmark federal funds rate are expected when the meeting concludes on Wednesday, the market is eagerly awaiting clues about the potential for a shift in the near future. 

The Path of Monetary Policy

To combat the highest level of inflation in over 40 years, the Fed rapidly hiked interest rates beginning in March of 2022. By the summer of 2023, fed funds had increased from near zero to a range of 5.25-5.50%.

As we entered 2024, it was widely believed the Fed was in a position to begin loosening monetary policy early in the year. A series of hotter-than-expected inflation reports beginning in January derailed that possibility, however. More recently, evidence that the labor market is softening, and inflation has resumed its downward trend has the market once again expecting the Fed will soon move to cut rates.

As of this writing, the market expects the Fed to cut its benchmark rate by 0.25% at the subsequent FOMC meeting in September. In total, the market is pricing in three cuts of 0.25% across the final three meetings of the year.

The Fed is hyper-focused on something they refer to as the ‘balance of risks.’ This term relates to the fact that their dual mandates of achieving stable prices and maximum employment are at odds with one another. Moves aimed at supporting one mandate often move the other in the wrong direction. If the Fed moves too quickly to ease policy, they risk allowing inflation to reaccelerate as it did in the 1970s under Chairman Arthur Burns. If they keep policy too tight for too long, they risk causing unnecessary harm to economic growth.

If the Fed can orchestrate a return to price stability and ease policy prior to inflicting undue damage to the economy, it would be said to have achieved a ‘soft landing.’ This scenario would be positive for the outlook on growth and inflation and serve as a tailwind for asset prices. In fact, as economic data has increasingly supported the notion that the Fed could soon loosen policy, we have seen a substantial rally across the bond and stock markets.

Likely Impact on Investors

The Fed exerts substantial control over short-term rates. A cut to the fed funds rate would quickly lead to a commensurate decline in the yield on cash instruments. Think money market funds, very short-term US Treasury bills, and likely CDs and high-yield savings accounts. The impact on other asset classes would be much less clear.

Stocks and bonds are driven by the outlook for growth and inflation, making these markets inherently forward-looking. They do not wait for a rumor to become news. Instead, they are constantly repricing based on expectations for the future. Consequently, some of the benefits of a loosening of monetary policy are already being felt.

The 10-year Treasury yield has declined by roughly 0.50% from its year-to-date peak of 4.70% in mid-April. Since that time, the bond market has returned +4.20%⁽¹⁾ while the US stock market has gained +7.96%⁽²⁾. Additionally, small-value stocks, which were disproportionately hurt by higher rates, have surged since the most recent inflation report on July 11th. Small value has outperformed large growth by approximately 18%⁽³⁾ since that point. These sizable market moves are generally attributed to the expectation of rate cuts.

Discipline is a critical attribute for investors given the forward-looking nature of the financial markets. Those who seek to time large shifts in their portfolios to let the dust settle or otherwise benefit from some prediction of the future may find that they’ve missed out on a large move by the time they are ready to act. Investors sitting in cash or concentrated in large growth stocks certainly did not receive a warning that the time to reposition may have already passed.

1. Based on the Bloomberg US Aggregate Bond TR Index
2. Based on the Russell 3000 TR Index
3. Based on the S&P 500 Growth TR Index and the S&P Small Cap 600 Value (TR) Index

Source: MarketWatch

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