Fed Delivers on Sizable Rate Cut

Fed Delivers on Sizable Rate Cut

In its first cut since the pandemic, the Federal Open Market Committee started strong, reducing the target range for its benchmark rate by 50 basis points to 4.75% to 5.00%. Since 1970, we have seen just one other non-recessionary easing cycle start with a cut of 50 basis points (1984). The Federal Reserve (Fed) kept its rate at the peak level for 419 days, the fourth longest pause since 1965.

Policy still restrictive

The Fed made the sizable rate cut likely because policy was still very restrictive, given the economy’s easing inflation and slowing growth rates. As shown below, the real policy rate for the US established by the Fed, even after the rate cut, is the most restrictive since the global financial crisis and of all major central banks.

The main economic argument against a 50 basis point cut was the risk of boosting growth and inflation. However, given the moderation in inflation and inflation expectations since July 2023, the 50 basis point reduction merely brought the real fed funds rate back to 2.5%, which was its level before the last rate hike. Essentially, the real policy rate had already increased by about 25 basis points since the Fed's most recent hike. Another concern was that a 50 basis point cut might lead the market to anticipate further reductions. The Fed responded by not fully confirming those expectations in the dot plot, shown below.

Participants forecasted 100 basis points of cuts this year and another 100 basis points next year, bringing the rate to a range of 3.25% to 3.50%. By 2026, the range eased to 2.75% to 3.00%, aligning with the upwardly adjusted longer-run neutral rate. This indicates that the market was slightly more aggressive in its pricing for next year than the Fed anticipated.

Soft landing on track

Although the labor market has softened and several sectors—such as manufacturing, housing market activity, and auto sales—have significantly slowed in response to restrictive monetary policy since 2022, the economy still appears to be on track for a soft landing. In fact, nine out of the ten indicators in the Ned Davis Research (NDR) Recession Watch Report are currently giving positive signals, suggesting that the near-term risk of a recession is low, as shown below. Given this backdrop, easing monetary policy could help extend the ongoing economic expansion.

This environment would be good news for equities. Easing cycles into soft landings have produced better long-term returns than ones into recessions by a wide margin. As the chart below illustrates, there have been nine cases in history where the Fed has cut interest rates while avoiding a recession, with an average return one year later of ~23%. This is perhaps one reason why markets rallied to new all-time highs the day following the rate cut announcement.

What’s next?

While the Fed’s 50 basis point rate cut signals a shift toward a more accommodative policy to address easing inflation and slowing growth, potential risks remain. Though the economy appears on track for a soft landing and recession risks are low according to key indicators, uncertainty still lingers. The market’s anticipation of further rate cuts could create volatility if the Fed doesn’t meet those expectations. Additionally, the global economic environment, geopolitical tensions, or unforeseen shocks could undermine the current trajectory and reignite inflationary pressures or destabilize growth. While easing cycles that avoid recessions have historically led to strong equity returns, it is important to maintain a measured perspective, as economic conditions and market sentiment can shift rapidly. As such, although the overall outlook is positive, we remain mindful of potential risks.

Third party sources and supporting documentation owned and provided by Ned Davis Research

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