What Will Happen If the Fed Doesn’t Cut Rates?

It’s been a long time since the Federal Reserve decided to return to a low-interest rate environment.

Although government data suggested inflation’s trajectory has been downward, the ride has been bumpy and not necessarily reflective of ordinary Americans day-to-day spending experiences.

While hopes were rising for impending rate cuts, recent readings have put those aspirations into jeopardy. So, what happens if there are no rate cuts this year? 

The Rapid U-Turn From 3 Rate Cuts To 0

In 2022, Americans’ consumer confidence took a big hit when inflation reached a fresh 40-year high.

Spikes in the costs of rent, insurance, and medical care took the consumer price index to an annualized 9.1% rate in June 2022, the fastest pace of price increases seen since 1981. There were other factors exacerbating inflation at that point, like the outbreak of the Russia-Ukraine war.

Even before that, there had been warning signs of inflation spiraling out of control, which is why in March of 2022, the Fed enacted its first interest rate hike, taking the benchmark rate higher by 25 basis points to a range of 0.25%-0.5%, thereby effectively ending the low-rate environment that Wall Street and Main Street had enjoyed for quite some time.

Stubborn inflation led the Fed to initiate 11 rate hikes in total between March 2022 and July 2023, aimed at bringing down inflation to a targeted 2% level.

The path had not been smooth for the Fed, with warning bells of a recession ringing virtually everywhere. In spite of the concerns, the U.S. consumer remained more resilient than anticipated.

Today, interest rates sit in the 5.25%-5.5% target range, the highest in 22 years, even as the Fed has not raised rates since July 2023.

Late last year on the back of a more optimistic outlook, the Fed penciled in at least three rate cuts for 2024. Furthermore, FOMC’s dot plot indicated another four cuts in 2025, and three more reductions in 2026, anticipated to take the fed funds rate down to between 2%-2.25%.

However, inflation readings this year have not been favorable to the Fed’s forecasts. In January, headline CPI stood at 3.1%. Although this was down from the 3.4% in December, it was also high compared to the 2.9% analysts were expecting.

This figure rose to 3.2% in February, exceeding the 3.1% consensus estimate. In March, inflation climbed to 3.5%  and once again topped the 3.4% estimate among analysts.

Such strong inflation readings for the first quarter of this year have dashed the market’s hopes of new rate cuts. Three rate cuts at this moment seem like a faraway thought.

Fed Chair Jerome Powell all but put a nail in that coffin by stating that the central bank is in no rush to cut rates. At this point, the possibility of no rate cuts this year cannot be ignored. The personal consumption expenditure (PCE) inflation is also not helping, not least because this is the Fed’s preferred inflation gauge.

Not All Data Points Are Negative

While inflation is still hurting the American consumer, not all data points suggest a negative outlook is warranted.

In March, nonfarm payrolls increased by 303,000 versus the expected value was 200,000. It is noteworthy though that the composition of jobs is what counts most in these reports to signal true economic strength. Part-time jobs and government sector hires mean less than full-time private sector roles.

Despite a January dip, February’s consumer spending picked up pace, as the CNBC/NRF Retail Monitor rose by 1.06% One factor that contributed marginally to this was the additional leap day on February 29.

March’s retail sales also did not disappoint, increasing by 0.7% for the month, well above the expected 0.3%.

Unemployment has been low and wages are increasing, which bodes well for the U.S. economy. Will the Federal Reserve be able to achieve the highly-coveted “soft landing” scenario as a result? 

What Will Happen If The Fed Doesn’t Cut Rates?

If the Fed doesn’t cut rates this year, the cost of debt will remain high hurting consumers spending capacity and putting downward pressure on the economy.

The domino effect in the economy from higher rates is to reduce money supply. Consumers tend to spend less during these times. While such policies take a long time to trickle through the economic engine, the effect on the stock market is typically more immediate.

Rising rates make it difficult for companies to raise debt capital and takes a toll on their profitability margins. As markets price in lower profitability, equities often struggle to power higher and investors take shelter in bonds.

As a testament to this, the 2-year U.S. Treasury Yield topped the 5% mark, after Fed Chair Jerome Powell remarked on the lack of progress combatting inflation. So, if interest rates don’t go down soon enough, investors increasingly shift from equities to debt markets.

Nonetheless, there are market spots that show resilience in such uncertain times. Healthcare is one of them, people don’t need “less” health ever. Utilities and consumer staples are equally always in demand through boom and bust cycles.

The financial sector is often a winner in these times, but following the regional bank crisis last year, caution in this sector is definitely warranted.

Among the most savvy plays at this time is to focus on companies with substantial cash hoards and solid balance sheets so that higher rates don’t cripple them with debt and they have the liquidity reserves to capitalize on opportunities if the economy tumbles. Berkshire Hathaway is a classic example of such a stock.

Dividend-paying companies are another interesting play at these times, particularly those with a long history of paying and increasing payouts, such as Coca Cola. By contrast, highly speculative growth names typically suffer most when economic weakness is prevalent.

What’s the Latest News?

Another unexpected blow came recently. The Commerce Department reported that Q1 gross domestic product rose by 1.6% (annualized). This looks bleak compared to the 3.4% growth in the prior quarter and the 2.4% rise analysts were expecting. 

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