Interest Rates 101 and Why They Matter

March 1, 2024

The Federal Reserve has been in the headlines lately as analysts try to determine when policymakers will cut interest rates.

Why do the unelected bureaucrats at the Fed matter so much?

The Fed’s decisions on interest rates are a big deal for markets and the economy because they affect how much it costs to borrow money. Since businesses and consumers depend on credit to buy houses, fund business growth, pay workers, and more, interest rate policy decisions ripple across the economy.

Higher interest rates make it more expensive to borrow money and can act as a brake on economic growth.

Conversely, higher interest rates can be a boon for savers and investors by increasing the yield on savings accounts, bonds, and other debt instruments. If you know someone putting off a new mortgage until rates come down or hunting down the best yield on a savings account, you are experiencing the Fed’s actions in play.

How does the Fed change interest rates?

At a high level, the Fed sets the “target” for the Federal Funds Rate, which is the rate banks and large institutions charge each other. Right now, that target is 5.25%—5.5%, and the actual “effective” rate is about 5.3%. Unfortunately, you and I do not have access to rates that low. The lending rates we can get from banks as consumers, investors, and businesses are set above that lowest rate.

Here is how that looks in practice.

The rates offered on the market to borrowers and investors are based on factors like risk profile, collateral, and loan length. You can see in the chart above that 30-year mortgage rates (maroon) are much higher than the base rate (black dotted), in part because of the length of the loan.

How does the Fed influence the stock market?

You might have noticed how much stock prices can swing when fresh headlines about the Fed’s decisions emerge. That is because all things being equal, lower interest rates are considered better for company performance because they incentivize borrowing and help fuel growth. When interest rates rise, companies must pay higher rates to access credit, which can hurt their prospects (and stock price). Since the stock market tends to be forward-looking, the prospect of lower rates can flip the “greed” switch and trigger a rally as investors bet on future company performance. That is what we have been seeing in the past few weeks.

When will the Fed lower rates in 2024?

That is the $64,000 question. We do not know exactly. The Fed is choosing to move carefully and assess the data. While we have made serious progress in taming inflation, there is still a way to go before reaching the Fed’s target of 2% inflation.

While many investors and economists hope the Fed will start cutting rates this spring and keep to their plan for multiple rate cuts this year, others are unconvinced.
We started the year with Landsberg Bennett believing there would be a possibility of three rate cuts while the majority of Wall Street Firms were projecting seven. We are now down to 0-2 rate cuts, while those other firms have moved their projections down to 3-5 cuts in 2024. Stay tuned.

We believe that the strong earnings growth we have just seen this quarter (around 8% year over year for the S&P 500), robust employment data, inflation still around 3% and not the Fed’s target of 2%, and major stock market indices at or near all time is not a time to cut interest rates. We also think the closer we get to the presidential election, the less decisively the Fed will want to move to try to stay out of the blame game for potentially playing favorites with one candidate over another.

What does all this mean for investors?

Markets will likely stay volatile as long as interest rates remain uncertain, especially approaching Fed announcement dates. Signs of lower inflation or other data supporting a cut will likely be greeted with further rallying. If inflation starts moving in the other direction, that could put pressure on stocks since that would diminish the likelihood of a rate cut.

Our models show inflation staying near 3% for the remainder of the year. It was relatively easy to raise interest rates to get inflation to come down from 9% to 3%; we believe that the last 1%, from 3% to 2%, will take much longer than many investors expect.

– Michael