Fed Rate Cut Begins (2024) - Will a recession follow?

Many experts predict that the U.S. Federal Reserve (hereafter referred to as the "Fed") will begin lowering interest rates this month, specifically on September 18, 2024, which is the second day of the upcoming Federal Open Market Committee (FOMC) meeting. According to the CME FedWatch as of August 17, 2024, the market assigns a 75% probability to a 0.25% rate cut and a 25% probability to a 0.5% rate cut at the next FOMC meeting. The Fed typically adjusts rates in increments of 0.25%, so a 0.5% cut would represent a significant shift. Furthermore, once the Fed starts adjusting rates, it usually continues in that direction through a series of gradual adjustments, which means the overall adjustment might be substantial.

The question that arises is how the Fed’s rate cuts might impact asset prices, particularly the U.S. stock indexes, which significantly influence global stock markets. Experts are sharply divided on this issue (as usual, more experts lean towards a continued rise in spite of or because of the Fed rate cut). Broadly speaking, there are three main perspectives: (1) The rate cuts are merely a response to an inevitable recession that has already begun to show signs, or the cuts are too late, which could lead to a stock market crash; (2) The U.S. economy is still robust, with a very low likelihood of a recession, so the rate cuts will reduce financial costs for businesses and households, stimulate investment, and further boost stock prices; (3) The possibility of rate cuts is already priced into the market, so the cuts themselves will not have any impact on stock prices unless something unexpected occurs, such as 0.75% cut. Additionally, there is a minority opinion that inflation is not yet fully under control, and premature rate cuts could reignite inflation, eventually forcing the Fed to raise rates again, leading to a stock market crash.

While different data may support different views, each argument seems plausible. Instead of trying to predict the future, I aim to review the past. Below is a graph downloaded from the website of the Federal Reserve Bank of St. Louis, showing the Fed's interest rate changes over a period of more than 50 years, starting from 1970.

The vertical gray areas indicate periods of recession in the United States. If the gray area is narrow, the recession was brief; if it is wide, the recession was deep. Even at a glance, it is clear that when the Fed begins cutting rates, a recession almost always follows (and when a recession occurs, stock prices plummet). In terms of timing, during the 1970s and 1980s, rate cuts and recessions occurred almost simultaneously, while after the 1990s, recessions followed rate cuts. This suggests that while the Fed might have been attempting to preemptively counteract a recession with rate cuts, it was ultimately unable to prevent a recession, whether it was short-lived or prolonged. So, was there no exception?

Fortunately, there are exceptions. Despite a significant rate cut starting in 1984, there was no recession. Additionally, small rate cuts in 1995 and 1998 were also followed by no recession (though the small scale of these cuts makes one wonder if they should be considered exceptions). The 1971 rate cut was part of a brief, indecisive adjustment between major cuts (recession), hikes, cuts (this is the part), and major hikes (recession), so I’ve excluded it.
So, how did U.S. unemployment rates behave during these times?

The blue line represents the Fed’s interest rate, and the orange line represents the U.S. unemployment rate. Until a recession begins, the unemployment rate tends to rise only slightly, but once in a recessionary period (gray areas), the unemployment rate invariably spikes. After the U.S. employment report was released on August 2, 2024, and Sahm’s rule was triggered, investor sentiment rapidly cooled, leading to a global stock market correction (though the unwinding of the yen carry trade was also a factor). Sahm’s rule, identified by economist Claudia Sahm, states that if the three-month moving average of the U.S. unemployment rate increases by 0.5 percentage points or more compared to the lowest rate in the past 12 months, it is considered the onset of a recession.

Now, let’s take a look at inflation.

The blue line represents the Fed’s interest rate, and the red line represents the U.S. annual inflation rate. As expected, inflation and the Fed’s interest rate generally moved in tandem. When inflation rises, the central bank raises interest rates to stabilize them. One notable observation is that until the 2008 global financial crisis, the Fed’s interest rate was generally higher than inflation. However, starting in 2009, even as inflation resumed its rise, the Fed kept rates effectively at zero until the end of 2015. In other words, real interest rates became negative. This meant that even if you deposited hard-earned money and received the principal plus interest at maturity, the purchasing power of that cash would have actually decreased. (As of the time of writing, the U.S. real interest rate is positive. But what does the fact that gold prices continue to hit all-time highs suggest?)

Bitcoin was officially launched by Satoshi Nakamoto on January 3, 2009. It’s no coincidence that Bitcoin emerged just as many countries around the world were printing vast amounts of money and increasing debt in response to the financial crisis, causing dormant inflation to reawaken while interest rates remained near zero, leading to a general decline in the real value of money.

I intended to keep this article short as an introduction, but it has become somewhat lengthy. As mentioned earlier, I plan to refer to past cases to see how major asset classes responded when the Fed began cutting rates. Besides U.S. stock indexes, I’d like to examine a few more. While there are many assets in the world, I am particularly interested in the S&P 500 (the leading large-cap U.S. stock index), gold (spot), Bitcoin (the leading cryptocurrency), and the USD/KRW exchange rate. Although real estate is one of the key asset classes that benefits from lower interest rates, I am more interested in highly liquid assets that can be quickly invested in or converted to cash at any time like ones that I mentioned earlier. In the next article, I will analyze three contrasting cases in 3 parts.

Thanks for reading. Wish you grow rich slowly and surely!

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