Blog with MAE Capital

We know the Federal Reserve has lowered its target overnight lending rate to 3.75% from 4%.   That sounds great to most people; however, is it signaling a slowdown in the economy, or is it responding to one?   The answer to this might very well surprise you.   We will also need to discuss where interest rates are going from here.  There is a lot at play in the financial markets currently that is not being reported in the mainstream media.

Let’s jump right in to why the Federal Reserve, or the “FED”,  lowered its rate in the first place.  The Fed lowers interest rates to stimulate the economy, and this has been done for decades.  The only interest rate the Fed has to work with is the Federal funds rate, or referred to as the overnight lending rate.  This is the interest rate that member banks can borrow from the Fed to accommodate their reserve requirements or to loan more money to their customers.  This is called fractionalized banking, where banks can lend out the majority of people’s savings held in their bank.  The idea of lowering rates is to stimulate banks to lend more money, so if the money is cheaper, they can lend at lower interest rates.   Lending at lower rates means lower rates for the consumer and businesses.

Ok, now that we understand how the lower Fed funds rates come back to the economy, we need to ask the question as to why they want to create more demand for money.  The main reason is to stimulate consumers and commercial borrowers to borrow more money.  By lowering interest rates, the idea is that people and businesses will borrow more money for expansion or to lower the payments on existing debt, freeing up more money to invest in the economy.  When the economy has more money, the theory is that it will create more jobs by companies investing in expansion, and it will put more money in the consumer’s hands to buy more stuff.  This demand side effect stimulates producers of goods and services to produce more, thus expanding the economy.  

This is all theory and has proven to work in the past, as it makes sense.  Will this strategy work this time, or will it not be enough or too much?   If the Fed lowers rates too much, what we see is inflation.  The reason we see inflation with low interest rates is that consumers will borrow more to buy more stuff, like houses and cars, and other goods and services.  If supply can’t keep up with demand for goods and services, then the cost of goods and services goes up with higher demand.  This is why it is a dance; every time the Fed does something with interest rates, it is basically an educated guess when they raise or lower interest rates.  When interest rates come down, the Fed also must authorize the printing of more money so it can accommodate the demand for it, and with the supply of money increasing, it can lower the value of the dollar, and you get inflation, which is a killer to all economies.  We have been seeing the devaluation of the dollar on the world stage over the last 5 years as the petro dollar is going away slowly (this is a discussion for another article).  This causes the price of foreign goods to go up.  The Tariffs that are being imposed on other countries on their goods being imported to the US are also something to be taken into consideration.  In fact, the tariffs that this administration has put on other countries scared the FED into believing that this would cause inflation, and that is a reason they have taken so long to lower interest rates.  

Next, we need to ask the question of where interest rates are headed in the future.  This will depend on how the Federal Reserve perceives the economy as growing or contracting.   If the economy shows signs of heating up and inflation continues to be outside of their 2% annual target rate, then they may not lower rates again in the near future.   If the Fed sees the economy as slowing still, with higher unemployment and low growth, they will continue to lower interest rates.   

What I believe will happen, based on my economic background of 40+ years, is that the data that is usually given to the Fed to make their economic decisions has been suppressed due to the government shutdown, and the Fed is running blind until the real numbers are revealed.  The Bureau of Labor and Statistics (BLS)is where the Fed gets the data to make its economic decisions, and the BLS has been far less than reliable over the last 5 years, with huge data corrections in the numbers they issue for the Fed to make decisions.  We have not had real unemployment numbers from the BLS since September, and those numbers were corrected later in the month to show a large number of people filing new claims for unemployment.  What this means is that the economy is in far worse shape than what is being reported, and when the Fed gets wind of what the actual numbers are they will have to lower interest rates.  I have worked in the mortgage business for 40+ years now, and I have seen many different market indicators, but this one has me seriously concerned.  The last two and a half years in my business have been extremely slow, with no real money moving.  This has been because the rates were way too low in 2020 and 2021and those who have those low rates have not wanted to refinance to a higher rate to take money out to help the economy. Then rates went from the 2’s and 3’s to 7% in a matter of months, effectively slowing down the economy and taking out a whole segment of people who now could not afford to buy a house.  I think that Interest rates will have to come down significantly in the next 6 months once the FED realizes that the economy is far worse than they imagined.  The wild card will be inflation numbers if jobs continue to be lost, along with higher inflation, which will give the Fed an almost impossible task.  Look for a new Federal Reserve Chair next year as Jerome Powell will be stepping down sometime in 2026.  One thing that will stay constant is change, so keep learning and make good financial decisions.