Economic Commentary

The Federal Reserve’s dual mandate, full employment and price stability, is a dynamic balance that requires constant attention. Supported by a hot labor market, the Fed raised interest rates from 0.00%-0.25% to 5.25%-5.50% over the 16 months ended July 2023 and held them there for over a year. Over that entire time, the priorities were inflation reduction and returning the labor market to a better balance between labor supply and demand. While the battle is never over, inflation fell precipitously from a peak of 9.1% in June 2022 to 2.4% in September 2024.

By the third quarter of 2024, with much of the heavy lifting on inflation complete, policymakers began to take note of a degree of deterioration in the labor market. While the job market had not become soft, it had clearly softened from an overheated starting point. In July, the Fed signaled a pivot for the committee’s focus by changing language in the July Fed statement to indicate the FOMC would be “attentive to the risks to both sides of its dual mandate” (inflation and labor market) compared to “highly attentive to inflation risks” previously. In September, the Fed cut interest rates by 0.50%, lobbing some support at the labor market in pursuit of the elusive soft landing.

With policy actions at the Fed shifting from tightening to loosening monetary policy, we thought now would be an ideal time to add historical context to the current anticipated rate cutting cycle. We analyzed the latest 15 cutting cycles, and, in this article, we will share perspective on potential similarities and differences in today’s outlook.

Historically, the Fed has often been behind the curve with policy moves. Not that it’s always their fault. Sometimes, unpredictable or exogenous events force the committee to be reactive. This time around, the Fed has the luxury of adjusting policy proactively and may be ahead of (or at least on) the curve for the time being. If that is true, it could mean the path ahead will play out differently than the historical experience.

In past cutting cycles, policymakers have reduced interest rates by an average of 4.70% over a period of 12 months. The bond market expects the current cutting cycle to extend through early 2026 with rates declining from a cycle high of 5.50% to 3.50% (2.00% in total cuts). In other words, investors are expecting the Fed to implement fewer cuts over a longer period – perhaps a reflection of the reactive nature of past cutting cycles.

The S&P 500 historically performed slightly better-than-average in the 12 months following the first rate cut. Returns in the six months leading into the first rate cut have been lower-than-average typically, but the S&P 500 returned 10% in the six months leading to the September 2024 rate cut. This reflects investors’ expectation that US large cap earnings will continue to grow.

Speaking of earnings, S&P 500 earnings per share have declined by an average of 4% in the 12 months following the first interest rate cut. Historically, interest savings were not enough to overcome the impact of slower economic activity that tends to precipitate a rate cut. However, looking ahead, consensus estimates are for S&P 500 earnings per share growth of 13% on a forward 12-month basis, which would require a significant downward revision for a negative outcome.

In terms of GDP growth, historically the Federal Reserve begins cutting rates during a relatively positive economy, with real growth averaging 2.7%. Real growth has tended to slow during rate cutting cycles as monetary policy impacts growth with a lag. Accommodative policy may help the economy recover but, historically, it has not staved off real GDP declines. As of Q3 2024, the economy has grown at a 2.8% real rate with little evidence of an imminent slowdown.

Inflation has typically declined during rate cutting cycles. As mentioned earlier, the economy has made a lot of progress on inflation, which currently registers 2.4%. It is common for the Fed to begin cutting rates prior to achieving their inflation target, with rate cuts in 1995, 2001, and 2007 all coinciding with inflation above 2%. Inflation forecasts are steady for the near-term with expectations of 2.3% by the time the Fed is expected to complete this rate cutting cycle in early 2026.

As for jobs, past cutting cycles have coincided with rising unemployment. In the past two cycles, the Fed hit the zero lower bound prior to the peak unemployment rate which in both cases reached double digits. In this cycle, forecasters anticipate a mild rise in unemployment to 4.3%. The October jobs report, heavily distorted by strike activity and two major hurricanes saw the slowest growth in payrolls since 2020, though the unemployment rate held steady at 4.1% while jobless claims have remained historically muted.

Payroll gains tend to turn to job losses during rate cutting cycles as the Fed responds to labor market weakness with more accommodative policy. In the current cycle, payroll gains have been stronger than at the start of four of the past five rate cutting cycles, signaling that the Fed is seeking to act before significant weakness emerges. A deteriorating labor market is one of the key risks to the economic expansion and we will be closely monitoring monthly jobs reports and weekly unemployment insurance claims.

Summarizing the outlook, investors and forecasters expect a mild rate cutting cycle in the context of low and stable inflation, a slight deterioration in unemployment despite steady payroll gains, and continued strong corporate earnings growth. Time will tell if this favorable backdrop evolves as expected, but as it stands, economists place a 25% likelihood on the prospect that the U.S. will enter a recession in the next 12 months. I like those odds. And while there are nascent indications of a slowdown, the prospect of avoiding a recession in the year ahead seems reasonable absent a significant Fed misstep or other exogenous shock.

At the end of the day, we build investment solutions with business cycles, recessions, geopolitical conflict and even black swan events in mind. We manage risk with diversification, discipline and the benefit of a long time horizon. Despite an ever-changing landscape, our disciplined approach and long-term orientation serve us well as we endeavor to create comprehensive investment solutions that help our clients reach their financial goals.