The Economist: The US Federal Reserve’s interest rate cuts may disappoint investors

The longed-for moment is almost here. For two and a half years, ever since America’s Federal Reserve embarked on its fastest series of interest-rate rises since the 1980s, investors have been desperate for any hint of when it would reverse course. Now it would be a huge surprise if Jerome Powell, the central bank’s chair, did not announce the first such reduction after its rate-setting committee meets on September 18. Indeed, among traders, the debate is no longer “whether” but “how much”. Market pricing implies roughly a 40 per cent chance that officials will cut their policy rate, currently between 5.25 per cent and 5.5 per cent, by 0.25 percentage points, and a 60 per cent chance that they will instead opt for 0.5.

Going by how investors have reacted to Mr Powell’s pronouncements over the past couple of years, you might think this is unadulterated good news for them. After all, America’s stock market has spent much of that time cratering whenever it looked like interest rates would stay higher for longer, and soaring on any suggestion that borrowing costs might soon come down. But it is not for nothing that “buy the rumour, sell the fact” is such an enduring mantra in financial markets. For all that the prospect of rate cuts sets investors’ pulses racing, their actual arrival has often proved disappointing.

Consider how share prices have responded to past loosening cycles. Although the three episodes in the 1990s, when Alan Greenspan was at the Fed’s helm, did give the stockmarket successive boosts, this century’s record has been drearier. Rate cuts in the early 2000s took place during the bursting of the dotcom bubble; those starting in 2007 coincided with the market crash that accompanied the global financial crisis. The doveish turn that began in 2019 buoyed share prices at first, but the effect was then swamped by the onset of the COVID-19 pandemic.

Like so much in finance, rate cuts have a small effect on share prices (in this case a positive one) that is easily obscured by other factors. The fillip comes from a reduction in borrowing costs, which allows companies to keep more of their profits and encourages customers to spend more on their products. If bond yields also fall, prospective returns on shares become that much more attractive by comparison, providing another boost.

What, then, might be the swamping factors this time? One is perennial: that money never gets cheaper in isolation, but because central bankers fear economic weakness and want to stave it off. Just now, that seems like less of a worry than normally is the case.

True, America’s labour market has cooled, which prompted a brief growth scare among shareholders over the summer. However, unusually for the end of a tightening cycle, the economy appears to be merely slowing down rather than entering a recession. Company profits should therefore be safer than usual as the Fed begins to cut — and so should share prices.

More worrying are the infamous “long and variable lags”, as named by Milton Friedman, between changes in monetary policy and their impact on companies and consumers. Counterintuitively, even as the Fed prepares to loosen, many borrowers will face steeper interest bills. Any firm that issued fixed-rate debt while money was nearly free, which is plenty of them, will eventually need to refinance.

Since there is little prospect of the Fed returning interest rates close to zero any time soon, debt-servicing costs for such firms will be rising for some time yet. Homeowners on fixed-rate mortgages who need to refinance (after moving house, for instance) will be in a similar position. So rate cuts may energise the economy, and hence the stock market, less today than they would have done in the past.

The biggest hint that the Fed’s largesse will disappoint investors, though, is the extent to which it is already expected by the market. Already, traders’ central expectation is for 1.25 percentage points’ worth of cuts before the year is out, followed by another 1.25 next year.

Such rapid moves have only occurred in the past amid recessions or crises. There is plenty of room, in other words, for Mr Powell to surprise on the hawkish side even as he slashes rates, which would raise bond yields and make stocks less attractive. Rate cuts ought to be good for the stockmarket. But not if investors have already pocketed their benefits.