Introduction to the Federal Reserve’s Rate Cutting Cycle
The Federal Reserve is getting ready to reduce interest rates again, which could have a significant impact on the economy and financial markets. This decision comes after two years of fighting inflation with aggressive rate hikes. Chair Jerome Powell recently indicated that the "balance of risks" is changing, which suggests that the Fed is shifting its focus from fighting inflation to supporting economic growth.
Current State of Fed Policy
The federal funds rate is currently at 4.25-4.50%, down from its peak in Q3 2024. At the July meeting, two Fed governors voted for a rate cut, which was the first open dissent in this direction during the cycle. The minutes from that meeting described policy as "moderately restrictive," with officials weighing the tug-of-war between tariff-driven price pressures and rising downside risks to employment. Powell’s recent speech in Jackson Hole was seen as a confirmation signal for investors, suggesting that the Committee is preparing to ease, though incoming data will dictate the pace.
The Data Behind the Fed’s Decision
The latest inflation numbers show headline CPI at 2.7% year on year and core at 3.1%. Services inflation continues to cool, but tariffs are lifting goods prices. The Fed’s preferred measure, core PCE, stood at 2.8% in June. The labor market is where the Fed’s attention has turned, with payrolls growing just 73,000 in July and the unemployment rate rising to 4.2%. The softness is concentrated outside healthcare, suggesting broadening weakness. Powell explicitly acknowledged that downside risks to jobs are rising, a subtle but important change in tone.
Market Reaction to the Fed’s Pivot
Bond markets are the first to respond, with 2Y Treasury yields falling after Powell’s speech, pricing in a September cut. Futures imply around half a percentage point of easing this year, consistent with the Street view. Equity markets have interpreted the pivot as supportive, with small and mid-cap stocks, which are more sensitive to financing costs and yield curve shifts, beginning to outperform. The risk now is less about direction and more about pace. If PCE comes in hot or August jobs rebound sharply, the Fed could hold steady in September and push the first cut to November or December.
Historical Context of Rate Cuts
History shows that markets behave very differently depending on whether cuts are insurance or recession-driven. Since 1970, the S&P 500 has gained on average between 6-16% in the year following the first cut. In cycles where cuts were made without a recession, equities returned closer to 18%. When the economy was already in recession, the average return dropped to around 5%. Small caps have historically outperformed large caps in the first year after cuts, reflecting their greater sensitivity to borrowing costs. The yield curve usually steepens, with front-end yields falling faster than long yields, producing a bull steepener.
What Investors Should Watch
The playbook is straightforward: watch core PCE for signs of whether tariffs are feeding through to sustained inflation. Focus on payrolls, revisions, and the unemployment rate for evidence of labor market cracks. Pay attention to Powell’s language in speeches and minutes about "balanced risks." FedWatch probabilities can be used to gauge whether cuts are already fully priced. If the Fed delivers a fine-tuning cut with growth still intact, investors should expect a constructive backdrop. Small and mid-caps can lead, breadth should improve, and investment-grade credit carry remains attractive.
Conclusion
The Fed pivot is near, and what happens after it depends less on the cut itself and more on the regime it signals. History shows markets can rally strongly after insurance cuts. But history also shows that when cuts arrive too late, volatility replaces relief. Investors now face the task of deciding which side of history this cycle will follow. The coming weeks and months will be crucial in determining the direction of the economy and financial markets. As the Fed prepares to cut interest rates, investors must stay vigilant and watch for signs of whether the cut is an insurance move or the start of a recession cycle.
