As the U.S. Federal Reserve gathers next week, stakeholders are analyzing the potential effect of an interest rate cut. Whatever the board decides, Ivey Business School Professor Dr. Stephen R. Foerster, CFA, said there will be winners and losers.
Foerster said lower ones tend to favor borrowers and hurt lenders and savers. Those holding more debt than savings see net benefits – most of the time. Much depends on whether they are locked in.
“Consumer sectors—staples and discretionary—along with the real estate sectors tend to benefit from cuts,” Foerster explained. “Any consumers who rely on credit benefit from lower costs and thus improve spending opportunities.”
“Similarly, falling mortgage rates will benefit households. How quickly the impact is felt depends on whether households have variable or fixed financing (ones)—if the latter, the impact won’t be felt until the time of renewal.”
Foerster advised that Fed rates only impact short-term ones. Banks tend to follow movements at the Fed as they set prime levels. Longer-term ones may be impacted by other factors, such as expectations of inflation.
It’s also important to remember the Fed’s mandate. It must effectively promote the goals of maximum employment, stable prices, and moderate long-term interest rates. Foerster explained that it’s a balancing act between higher employment and lower inflation. The Fed tends to raise interest rates or tighten monetary policy when the economy appears to be overheating, which might lead to higher inflation. The reverse is true when the economy appears to be weakening.
“Currently, the Fed has helped curb inflation, which has declined from a recent peak of 6% (personal consumption expenditures measure) in April 2021 to its target of 2% in July 2023, currently at an annual rate of 2.8%,” Foerster said. “The Fed appears comfortable lowering interest rates now to help stimulate the economy since inflation is now under control.”
Foerster said the timing of the impact of Fed cuts is somewhat unpredictable. He likened a central banker’s job to driving a car on a windy road in the pouring rain with faulty windshield wipers. They see where they’ve been through the rearview mirror, but it’s not clear where they’re headed.
Lower interest rates are generally favorable for both bondholders and stockholders. For bondholders, Foerster said there is an inverse relationship between bond prices and interest: when interest declines, bond prices go up.
For stockholders, the price paid should reflect the present value of expected cash flows or dividend payments. When interest rates decline, the discount declines, making the stock more valuable.
“But with a Fed cut, this just lowers the risk-free rate and doesn’t impact on the riskiness of a corporate bond, or of stocks,” Foerster concluded.
