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Key takeaways

  • At its mid-September meeting, the Federal Reserve is likely to cut interest rates for the first time since 2020.

  • The Fed’s policymaking Federal Open Market Committee (FOMC) hasn’t changed interest rates since July 2023.

  • The market’s primary question is how far and fast the Fed may cut rates.

Long-awaited cuts to the federal funds target rate controlled by the Federal Reserve (Fed) appear likely this month. The policymaking Federal Open Market Committee (FOMC) meets on September 17-18 and is expected to lower interest rates at that meeting. It would represent the first Fed rate cut since 2020.

“Investor expectations have really consolidated around a rate cut being priced into the Fed’s September meeting,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.

Markets have anticipated such Fed action for months, but rate cut speculation increased after a disappointing July labor market report showing rising unemployment and slowing job growth. During that same month, inflation fell below 3%.1 Fed Chair Jerome Powell appeared to confirm the Fed’s September plans, saying in late August “The time has come for (interest rate) policy to adjust.” Powell noted that, “The upside risks to inflation have diminished. And the downside risks to employment have increased.”2

“Investor expectations have really consolidated around a rate cut being priced into the Fed’s September meeting,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “We’re seeing signals from asset prices confirming a broader, gradual deceleration of the fed funds rate as well as a focus on worldwide rate cuts,” from other central banks.

“Investor expectations have really consolidated around a rate cut being priced into the Fed’s September meeting,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “We’re seeing signals from asset prices confirming a broader, gradual deceleration of the fed funds rate as well as a focus on global rate cuts,” from other central banks.

Chart depicts the Federal Reserve's target federal funds rate 2000-July 31, 2024.
Source: U.S. Federal Reserve, July 31, 2024.

What drives Fed interest rate decisions

Since early 2022, the Fed has focused on inflation, with interest rate policy designed to slow the rapid rise in living costs. Inflation, based on the Consumer Price Index (CPI), has declined considerably, from more than 9% for the 12-month period ending June 2022, to 2.9% for the 12 months ending July 2024.1

Chart depicts inflation rate as represented by the Consumer Price Index from June 2022 - July 2024.
Source: U.S. Bureau of Labor Statistics. As of July 31, 2024.

However, the state of the job market is taking on increasing importance, says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The keys to what the Fed does now are labor market data. While the August jobs report will provide telling information, the Fed looks at multiple data points over time, not a selected point in time.” Haworth notes that initial jobless claims provide a helpful “real-time” guide on the state of the jobs environment. “Initial claims continue to hold within a modest range, which shows that the labor market remains stable for now,” says Haworth. Initial jobless claims in mid-August were below the level from the same period one year earlier.3

Chart depicts initial jobless claims from August 2023 to August 2024 according to the U.S. Employment & Training Administration (as of August, 17, 2024).
Source: U.S. Employment and Training Administration. As of August 17, 2024.

Markets are sensitive to the Fed

Markets suffered a temporary setback in the immediate wake of July’s weaker-than-expected jobs report. The S&P 500 declined nearly 9% below its mid-July peak, while the NASDAQ Composite Index fell into market correction territory (a decline of 10% or more from peak levels). Investors were concerned that the Fed’s failure to cut interest rates at its July meeting put the economy at risk. But other economic data released since that point seemed to allay those fears.

As a result, stocks quickly regained lost ground, and by late August, the Dow Jones Industrial Average topped its all-time record. The S&P 500 and NASDAQ Composite indices remain only modestly below their respective July peaks.

 

How fast will the Fed cut rates?

The CME FedWatch Tool, which analyzes the probabilities of fed fund rate changes based on interest rate trader actions, indicates a high likelihood of a 0.25% rate cut at the FOMC’s September meeting. A smaller number of traders project an initial rate cut of 0.50%.4

Chart depicts the likelihood of Federal Reserve interest rate cuts at upcoming meetings (as of August 28, 2024).
Source: CME FedWatch Tool, as of August 28, 2024.

“The question for the Fed is whether they are focused on normalizing rates and cutting at a slower pace, or jump-starting cuts to change the environment more quickly,” says Haworth. “Based on what we know now, a 50-basis point (0.50%) rate cut would be a surprise.” Haworth says the markets prefer the Fed sends clear signals prior to making its interest rate policy decisions. He will be keeping a close eye on comments by Fed officials leading up to September’s FOMC meeting.

 

Reducing the Fed’s balance sheet

Dating back to the financial crisis of 2008, the Fed has routinely purchased bonds to bolster market liquidity. However, starting in March 2022, the Fed began reducing its bond holdings. In June, the Fed adjusted its policy, slowing the reduction in its Treasury holdings from $60 billion per month to $25 billion per month. The Fed continues to trim its holdings of mortgage-backed securities by $35 billion per month. “It appears the Fed is more focused on trying to work off its book of mortgage-backed securities,” says Haworth. The Fed’s balance sheet of asset holdings grew to just under $9 trillion in early 2022. It’s now been reduced to $7.14 trillion.5 “It seems unlikely the Fed will drop its balance sheet back to the $4 trillion level, as it stood in 2015-16, but given the extent the economy has grown since then, a larger Fed balance sheet may be justified,” says Haworth.

Chart depicts dollar amount of assets on the Federal Reserve’s balance sheet between April 2022 and August 21, 2024.
Source: Board of Governors of the Federal Reserve System (US), Assets: Total Assets: Total Assets (Less Eliminations from Consolidation), retrieved from FRED, Federal Reserve Bank of St. Louis. As of August 21, 2024.

U.S. economy continues to grow

Despite significant Fed monetary tightening, the U.S. economy remains resilient, and it appears that the Fed expects growth to continue. First quarter 2024 annualized Gross Domestic Product (GDP) growth came in slightly lower than expectations, at 1.4%, but second-quarter GDP doubled that pace, expanding at an annualized rate of 2.8%.6 “The consumer is still hanging in there,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. “However, the environment may be getting a little tougher for lower-income consumers.” Notably, FOMC members, in their most recent estimate, anticipate that GDP will expand 2.1% over the year, a slight drop from 2023’s 2.5% GDP growth rate.7

Be sure to consult with your financial professional and review portfolio positioning to determine if changes might be appropriate given your goals, time horizon and feelings toward risk in today’s evolving interest rate environment.

Frequently asked questions

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Disclosures

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  1. Source: U.S. Bureau of Labor Statistics.

  2. Board of Governors of the Federal Reserve System, “Transcript of Chair Powell’s FOMC Press Conference Opening Statement,” July 31, 2024.

  3. U.S. Employment and Training Administration. As of August 17, 2024.

  4. CME Group, FedWatch, as of September 11, 2024.

  5. Board of Governors of the Federal Reserve System (US), Assets: Total Assets: Total Assets (Less Eliminations from Consolidation), retrieved from FRED, Federal Reserve Bank of St. Louis. As of August 21, 2024.

  6. Source: U.S. Bureau of Economic Analysis.

  7. Federal Reserve Board of Governors, “Summary of Economic Projections,” released June 12, 2024.

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