There have been recent headlines regarding potential rate cuts by the Federal Reserve (Fed). In the midst of one of the most expansive economies on record, what would this mean for the markets? Will it spark the beginning of a recessionary period? Let's take a deeper dive into what happens when interest rates are raised or lowered.
If you have ever taken out a loan to purchase a car or a home you have experienced the lender-borrower relationship. The lender is granting the use of funds in exchange for predetermined interest payments. When the interest rate is discounted, borrower demand increases. More people (on average) will take out a mortgage on a house or finance an automobile. The borrower enjoys a discount on borrowed funds.
According to LPL Research, since 1975, the Fed has cut rates 26 times with the S&P 500 Index up at least 15% for the year, most recently in 1995 and 1998. In the past thirty-five years, within a year of the cut, the S&P 500 has increased 23 out of 26 times. One of the main drivers for the drastic market expansions, after the rate cut, is increasing investor confidence.
In the 1930s, in the midst of the Great Depression, economist John Maynard Keynes developed a theory that advocated Fiscal Policy as a means of attaining an economy of full employment. Keynes believed in consumption and capital spending being the main driving forces of growth. With higher employment and more individuals and businesses spending, a trickle-down effect occurs. In order to stimulate an increase in consumption, the Fed will lower interest rates to encourage borrowing.
When the Fed becomes dovish, investor psychology turns to the principal of urgency. According to Freudian psychoanalysis, when one seeks out an immediate deal they satisfy the biological and psychological needs of avoiding pain. On the other hand, when the Fed becomes hawkish and hikes rates, one feels the stress of having to pay more. Investors are drawn to deals, and when rates are lowered they are given the nudge of confidence needed to spend freely.
Lowering interest rates could cause inflation to increase thus lowering purchasing power. If interest rates are lowered, demand for loans by individuals and businesses increases. By adopting a more expansionary monetary policy and decreasing the reserve requirement, the Fed will expand the money supply and accelerate the rate of inflation. With more free-spending and increase investor confidence, economic expansion could occur.
If you have any questions or comments regarding anything discussed, feel free to contact me or any members of my team.