The Federal Reserve just lowered the Federal Funds Rate by half of a percent, kicking off the first easing cycle since the COVID pandemic began. There was a debate whether rates would be lowered twenty-five or fifty basis points. The Powell Fed opted for a larger initial rate cut. It now sees balanced risks of weak labor markets and higher inflation and is intent on moving rates lower by about a percent this year to make sure emerging signs of a less strong labor market do not turn into larger job losses and a recession.
The question becomes how low will short-term interest rates go in this rate-cutting cycle? It is obvious, but it must be emphasized that falling inflation should be good for consumers, the economy, and stocks unless it is due to a recession. Absent a recession, the Federal Funds rate probably bottoms somewhere between three and four percent. While lower interest rates increase the value of future earnings, they also coincide with lower earnings multiples when accompanied by declining earnings and a recession. If a recession develops, two percent on the Fed Funds rate is possible. NPP hopes interest rates will not drop below two percent again. We do not think it is healthy for short-term rates to go below the inflation rate.
The S&P 500 dropped slightly on Wednesday despite the cut in interest rates. It has rallied significantly since bottoming at 5,186.33 on August 5th, up 8.32% as of Wednesday’s close. Another pullback after a strong move during a seasonally weak part of the year is possible. If a drawdown occurs, it should be bought by patient long-term investors.