The U.S. economy is doing well, so why cut interest rates? The Wall Street Journal: The Federal Reserve faces a complex situation

The Federal Reserve is expected to start cutting interest rates after this Wednesday's FOMC meeting. An article in the Wall Street Journal on Monday stated that this rate cut is being initiated under the condition of a still viable economy. Over time, the rate cut is expected to impact areas such as credit cards, mortgages, and savings. However, the uncertainty lies in how these impacts will specifically transmit to various sectors and what effects they will produce. The Federal Reserve needs to deal with a complex situation.

Cutting interest rates under a viable economy without precedent

The article mentioned that the mechanism of cutting interest rates has always been clear, with borrowers seeing a reduction in debt interest and savers experiencing lower cash returns. However, these are just macro-level overviews, and the specific operational methods remain a mystery.

Moreover, each rate-cutting cycle is different, and the economic response is both lengthy and variable. Nobel laureate in economics, Milton Friedman, likened the changes in Federal Reserve policy to "a faucet, you turn on the faucet now, and the water starts flowing out in 6 months, 9 months, 12 months, 16 months."

Cutting interest rates under the current circumstances has no clear precedent in U.S. history. Typically, before the Federal Reserve starts cutting rates, the economy has already experienced severe problems. But this is not the case now, as the U.S. labor market, although cooling off slightly, is still performing well, and the economy has been steadily growing.

In fact, the current economic situation in the U.S. is even better than in 1995 when the Federal Reserve successfully achieved a so-called "soft landing," with inflation falling and unemployment not rising significantly.

Analysts believe this may lead to an unusually different economic response following the Federal Reserve's expected rate cut on Wednesday.

For example, since the Federal Reserve's rate cut is not an attempt to reverse a sharply deteriorating economy, such as when people are not generally worried about losing their jobs imminently, lower rates may accelerate spending more quickly. On the other hand, stock and other asset valuations are still at relatively high levels, so it is unclear whether the rate cut can provide more impetus.

Restrictions on rates remain after the first rate cut

The Federal Reserve cannot control all interest rates; it can use policy tools to lower short-term rates for interbank overnight loans. After the Federal Reserve cuts rates, banks subsequently lower benchmark rates, which are crucial references for credit card debt and other loans. Long-term rates, such as mortgage rates, also tend to decline.

To curb inflation, the Federal Reserve has raised rates 11 times since early 2022, pushing the target rate from near 0% to around 5.4%. The same logic applies to rate cuts, meaning that it will take far more than one or two rate cuts for households and businesses to truly feel the change. It is currently expected that the Federal Reserve will cut rates by 0.25% or 0.5% this week.

Analysts believe that even after the first cut on Wednesday, rates may still remain at restrictive levels. Three models maintained by the Atlanta Federal Reserve show that the rate levels that neither stimulate nor slow down the economy are between 3.5% and 4.8% Even so, the rate cut will make life a little easier for some borrowers. Credit card rates closely follow the Fed's overnight target rate, so these rates are expected to decrease slightly. Small businesses using floating rate loans will also see a reduction in their interest payments.

The impact on the real estate market is still unknown

Wednesday's rate cut is likely just the beginning of a series of cuts. Futures markets indicate that investors believe the Fed will cut rates by a total of 1.25% by the end of this year, and another 1.25% in 2025.

The Fed sets short-term rates, but what has the greatest impact on long-term rates is investors' expectations of the Fed's future actions. In other words, the effects of a rate cut often manifest before the cut actually takes place.

This is reflected in the 10-year Treasury yield, which has now dropped to 3.65%. This is a full percentage point lower than in April and much lower than the 5% in October last year.

The 10-year Treasury yield has a significant impact on mortgage rates. According to Freddie Mac's data, the average rate for a 30-year fixed-rate mortgage has dropped to 6.20%, compared to 7.22% in early May this year.

However, it is still unclear at what level mortgage rates need to drop to reinvigorate the real estate industry. Housing prices remain high, making it difficult for many first-time homebuyers to enter the market.

In recent weeks, there has been a sign of growth in new mortgage applications for home purchases. However, compared to when mortgage rates first dropped below 7% last year, the volume of applications is still low, reflecting the importance of the rate "integer threshold". Some analysts predict that if mortgage rates drop below 6% or even 5.5%, there may be another surge in housing demand.

The direction of mortgage rates not only depends on changes in the Treasury yield. Many analysts believe that even if the 10-year Treasury yield remains unchanged, mortgage rates may still decrease slightly. A key component of mortgage rates is the additional spread that lenders charge above the long-term Treasury yield. Historically, a decrease in short-term rates often brings mortgage rates closer to the 10-year Treasury yield.

Expected boost in corporate equipment investment

Furthermore, another area that may receive a boost after the rate cut is corporate investment in equipment, covering all equipment from tractors to computers.

Currently, the cost of borrowing for large enterprises through corporate bonds has decreased, but rates for small businesses relying on credit card borrowing remain high. However, with the Fed's rate cut, these rates are expected to decrease.

Typically, lower rates take time to translate into faster investment growth. But analysts believe that a current variable is that corporate spending on equipment is particularly weak. According to data from the U.S. Department of Commerce, adjusted for inflation, since the end of 2019, corporate spending on equipment has only grown by 5.3%, while the overall U.S. GDP has grown by 9.4%.

Dan McManamon, CFO of Ohio Machinery, stated that his company has postponed spending on equipment such as service trucks and tool equipment. Customers have done the same "Some people say they will make purchases, but they are just waiting," he said. When interest rates are cut, "we may have our marketing department seize this opportunity."

Interest rate cuts also have other indirect effects.

One way is through the foreign exchange market. When US interest rates fall relative to those of other countries, it often weakens the US dollar. This in turn makes US products cheaper and therefore more competitive. However, this impact may be weakened by the fact that many other central banks are also cutting interest rates.

Another impact is the rise in asset prices, which is a common consequence of interest rate cuts. Higher stock prices can make it easier for companies to raise funds and make management more confident in approving projects. People who own stocks may increase their spending because they feel wealthier, although many economists believe that the importance of this so-called wealth effect is not as significant as it used to be.

Moreover, the direction of interest rates is more important than the level. Both households and businesses may feel better simply knowing that the Federal Reserve has cut interest rates and is likely to continue doing so. This alone could reduce the likelihood of an economic recession.