Could the Economy Fall When the Fed Lowers Interest Rates?

Ever since the inflation print that changed the world in November of 2021, Jerome Powell and the United States Federal Reserve jacked up interest rates to levels not seen in two decades. The logic behind this policy is that higher interest rates increase borrowing costs and make investment more difficult and generally slow down the economy. If the economy is slowing, then that will tame inflation.

It largely worked, although given that the COVID shock created the inflation countries around the world are still dealing with today, it will likely take years if not decades to fully unpack all the causes and solutions of this era where everything costs more.

One thing that’s clear is that greedflation, where companies ratchet up prices on goods and services, is a big part of the economy’s resilience.

Just recently, companies like Walgreens, Target, Walmart, Aldi, and McDonald’s have announced they are slashing prices, as consumers balk at paying more money for the same stuff. High interest rates did not hurt corporate balance sheets as much as anticipated, because most of these companies locked in borrowing costs when rates were near zero. This created a situation where these companies were goosing their profits through greedflation while the Fed’s attempt to slow their profits through higher interest rates never really materialized.

These companies’ higher profits were a surprise to Wall Street analysts. Coming into this year, most market observers expected the Fed’s high interest rates to dampen corporate profits and bring the market down, but the opposite has occurred.

David Uberti of The Wall Street Journal has an interesting article out today titled “Americans have more investment income than ever before,” and it highlights some of the dynamics in the economy that run counter to many people’s expectations of what should happen under a high interest rate regime.

The stock market is at all-time highs, fueled by a lot of empty artificial intelligence hype. A controversial take long pushed by lefty economists like Stephanie Kelton and now accepted by more mainstream finance types is that high interest rates increase asset prices and actually contribute to inflation. This theoretically should run counter to the fundamental math at the base of capitalism, which says higher interest rates devalue future cash flows and thus stock prices. Josh Bown, CEO of Ritholtz Wealth, asserted on CNBC that rich people actually like high interest rates because of the wealth effect they create in fixed income.

“There’s a reason why wealthy people absolutely love higher rates,” says @downtown. “They earn stock-like returns without taking any risk.” pic.twitter.com/aTykuNlkZ3

— CNBC’s Closing Bell (@CNBCClosingBell) April 17, 2024

Uberti’s article backs up Brown’s point, particularly this passage.

Americans in the first quarter earned about $3.7 trillion from interest and dividends at a seasonally adjusted annual rate, according to the Commerce Department, up roughly $770 billion from four years earlier. In the last quarter of 2023, wealth held in stocks, real estate and other assets such as pensions reached the highest level ever observed by the Federal Reserve.

Counter to a lot of conventional wisdom on Wall Street, high interest rates can actually create wealth, not just destroy it. Sure, borrowing costs are more expensive, but if you have $5 million in cash, you’re more than happy to put it in a money market fund earning five percent and pocket a risk-free quarter million dollar profit every year.

Instead of tamping down on future cash flows, high interest rates have provided people with more cash in the present, and a lot of that is helping to fuel this economic boom. Which begs the question, when the Fed does inevitably lower interest rates, what happens?

Crash?

What happens when that cushy risk-free five percent falls down to two or three percent along with the Fed Funds Rate? Will people still have the disposable income to speculate on one of the most expensive stock markets in history even as the cost of average food prices are up 20% from three years ago and the cost of basic necessities rises at the fastest rate in two decades? What happens to Target and everyone else who now are lowering prices and cutting into their profits?

If Americans earned $3.7 trillion from interest and dividends under five percent interest rates, then under four percent interest rates that quarterly figure should drop about twenty percent, wiping out almost a trillion dollars of wealth created from fixed income and dividends. That would certainly have a negative effect in some parts of the economy.

The rent is too damn high because America stopped building housing and pushed its price up astronomically, and now high interest rates are exacerbating this issue, making it even more expensive for people to buy or rent. Lowering interest rates would surely help those struggling to afford rent, but it would also reduce the disposable income for landlords, who largely exist in a wealthier class. As Josh Brown pointed out above, the wealth effect created by high interest rates among this wealthier class is a big part of what is helping to keep this economy humming.

Given the dynamics we have watched unfold in the economy over the last couple of years, where it has weathered the storm of high interest rates far better than any traditional economist expected, it’s not unreasonable to question that lowering interest rates could hurt the broader economy even as it helps many of those struggling to make ends meet in interest rate-sensitive sectors like housing. Economist Mark Zandi believes that these record corporate profits actually helped stop the most widely anticipated recession in American history.

This is the bizarre dynamic we find ourselves in, where the overall economy is doing good while most people say they feel extremely squeezed by high prices. High interest rates helped lead us into this confusion, so it’s fair to question if reversing those policies would create the opposite dynamic we have experienced to date.

In all this weird monetary mess, one thing is for certain: traditional notions of what do and do not work in the economy do not universally apply, and there are seemingly surprises around every corner now.