Why Interest Rate Cuts Matter – Technologist

The Federal Reserve voted on Wednesday to cut the central bank’s effective interest rate by a quarter-point. It’s the third such rate cut this year, marking a combined 1% reduction. And the bank’s target rate now sits at 4.25% to 4.5%.

It seems like a big deal. Every major news outlet reports on any Fed interest rate movement. But why do interest rate cuts matter? What happens as a result? And how does this affect you and your wallet?

5 Reasons Why Interest Rate Cuts Matter

The Federal Reserve (or “the Fed”) exists to meet a “dual mandate” of maximum employment and stable prices (inflation). Manipulating interest rates is the Fed’s most powerful monetary policy tool.

If the economy sputters, it can cut rates to improve the job market and speed up economic activity. Cheaper money in the form of lower interest rates on mortgages and business and auto loans can help boost spending, employment and economic confidence.

Raising rates can help curtail economic activity and inflation over time as borrowing money and servicing debt becomes more expensive.

Here’s a partial list of the items that rate cuts impact (along with the inflation rate):

• Mortgage rates
• Auto loan rates
• Business loan rates
• Personal loan rates
• Savings account interest rates
• Certificate of Deposit (CD) interest rates
• Credit card interest rates
• Series I savings bond interest rates
• Annual Cost of Living Adjustments (COLAs) to Social Security

Now let’s run through the biggest reasons why interest rate cuts matter.

1. Sets a Baseline for Banks

Banks use the federal funds interest rate when they lend each other money daily.

Although individual members own credit unions, which in theory work in the best interests of its customers (its owners), banks are for-profit entities.

Banks want massive piles of money. The bigger the money pile, the more loans a bank can make in the form of mortgages, auto loans, personal loans and credit card loans.

That’s why banks offer interest on savings accounts and CDs. The banks want to incentivize you to hold your money with them, so they can turn around and lend that money to someone else at a higher rate.

If a bank can access funds at, say, 4.25%, it has little incentive to offer you a 4.5% interest rate on your savings. If it needs more dollars to make loans, it can just borrow from other banks at a cheaper rate.

2. The Price of Borrowing Money and Debt Management

In general, lower Fed interest rates reduce the cost of borrowing.

Lower rates can lead to spending more on big-ticket items such as houses, vehicles and small businesses. In turn, that can stimulate the economy.

So if economic activity is too slow, the Fed can cut interest rates to attack that problem.

The same goes for managing debt with variable interest rates. Credit card debt is a good example of that. Many factors determine the exact rate you pay on each credit card. But Fed interest rates influence the general trend. Rate cuts lead to lower interest rates on your running credit card balances.

The shorter the timeframe on a loan, the more impactful a rate cut will be. For example, a bank offering a 30-day CD must adjust quickly to any interest rate cut. And it must make sure the rate it offers makes sense in light of the Fed rate.

However, a fixed-rate 30-year mortgage must take into account the interest rate outlook for years and even decades into the future. So a single quarter-point rate cut may not have much impact vs. the broader intermediate- and long-term economic outlook.

Overall, cheaper money means more consumer spending and more business investment.

3. Stock Market Impact

Depending on who you listen to, the stock market is brutally efficient or sometimes totally irrational.

In theory, in the long term, a company’s stock price should reflect its revenues, profits and future outlook.

Markets love predictability. Being able to know and project variables such as interest rates and the pace of consumer spending makes it much easier to project the future outlook of a specific business.

Some speculated that’s why the Fed slashed another quarter-point off the interest rate despite inflation creeping up to 2.7% again in November.

The Fed’s stated goal for the inflation rate is 2.0% year-over-year. And generally, you raise rates to counter inflation and slow spending down.

Also, when fixed-income investments and savings interest rates are lower, more people seek out the potential for higher returns by investing in the stock market.

4. Consumer and Business Confidence

With a somewhat decent job market and inflation threatening to reach 3% again, one may expect that the Fed should hike rates, not cut them.

But market expectations are important. If the Fed defied all expectations, did a 180 and suddenly started hiking rates again, it likely would crush consumer confidence and may even inspire some stock market panic selling. Rate cuts also help boost consumer confidence and signal that the Fed is acting to support the economy.

Sometimes the comments that the Federal Reserve chairman (currently Jerome Powell) makes at the end of Fed meetings can impact the stock market more than the decision to raise, cut or hold rates. Because it gives insight into the future outlook.

The Fed often tries to signal what its next move could be based on the current information so that the market and consumers aren’t shocked.

5. Exchange Rates

Interest rate cuts can cause the dollar to depreciate as investors seek higher returns elsewhere. A weaker dollar can boost exports by making them cheaper for foreign buyers.

However, that’s assuming that rate cuts happen in a vacuum. Often many of the world’s biggest central banks are moving in the same direction (all cutting rates or hiking rates on a similar timeline, for instance). So the dollar’s relative strength may not be impacted much if the United States is following the same path of other major economic powers.

Final Thoughts

Inflation in the United States topped the stated 2% goal in March 2021 (2.6%). At the time, media reports and officials believed inflation was transitive.

But after peaking at 9.1% in June 2022, it has proved stickier than almost anyone imagined at the time — and in fact is 0.1% higher than it was in March ’21 even 45 months later.

Still, the Fed made a third consecutive interest rate cut, dropping rates by a combined 1% during that time. We’re entering a period of much greater uncertainty in ’25 — politically and economically.

It’s much less clear what the Fed will do moving forward, and it probably will depend on what happens with inflation in the coming few months.

Hopefully, I’ve helped you understand what happens when the Fed cuts interest rates, how it matters economically, and how it may affect you.

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