Written by: Andrew D. Rohrer
On July 31st the Federal Reserve announced a ¼ point cut to the Federal Funds target rate. Many investors were left staring at the television asking, “What does this even mean?”
In order to understand the impact, one must first understand the role of the Federal Reserve. The “Fed” plays multiple roles, the most visible of which is to conduct monetary policy. By influencing the supply of money and credit in the economy, the Fed hopes to both maintain price stability and achieve maximum sustainable employment. These two goals are known as the “dual mandate.” In practical terms, the Fed believes an economy with 2% annual inflation reflects stable pricing. Maximum sustainable employment is a bit vague but is generally recognized as a labor environment in which unemployment rates are contained to around 4%.
The Fed will occasionally, like on July 31st, change the Fed Funds target rate in order to achieve its dual mandate. This key interest rate is the cost banks charge each other for borrowing. A high Fed Funds rate typically results in higher costs (interest rates) for individuals and corporations to borrow money. This tends to discourage borrowing, and subsequently, spending. A low Fed Funds rate may result in lower borrowing costs for consumers and increased bank lending activity. Theoretically, low rates should promote economic growth as both individuals and corporations increase their spending.
So, what does this mean for investors?
Consumers often think a rate cut means all borrowing rates will fall simultaneously, but this is not necessarily true. For example, fixed mortgage rates move with longer-term expectations and are typically compared to 10- or 30-year Treasury yields. The yields on some shorter-term savings vehicles like money markets and newly-issued short-term CDs may see lower yields more immediately.
So, how does an interest rate cut affect the stock market? This can be a little more difficult to decipher. The market may increase after a rate cut as investors anticipate lower borrowing costs, increased consumer spending and economic growth. However, this may not always be the market’s reaction. Stock price movements are influenced by many other factors including corporate earnings, geopolitical risks and global economic activity. To further complicate the situation, any differences from broad investor expectations, like a surprisingly large or small interest rate change, can cause market volatility as investors reprice assets in the new, unanticipated rate environment.
Interest rate changes are difficult to predict. Even seasoned investment professionals and economists often incorrectly guess the timing, magnitude and frequency of Fed activities. At Domani Wealth, we believe that proper planning is the best solution to keep our clients on course to meet their financial goals. We encourage a longer-term perspective to investment management that includes prudent asset allocation and appropriate diversification. If you have questions about your portfolio or would like to meet and review your financial picture, please call our office for an appointment.
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