Key Questions: 25 or 50 … Is That Really the Question?

After raising interest rates by the largest amount and fastest pace in over a generation over the past two years, the Federal Reserve (“the Fed”) is poised to cut interest rates when it meets on Wednesday, September 18. There is little debate over that; it is all but guaranteed.

That said, there is a significant debate about the size of this week's initial Fed rate cut. Will it be 25 basis points (0.25%) or 50 basis points (0.50%)? Here's what history has to say on the subject.

Since 1990, The Fed initially cut interest rates by 0.25% on three occasions: July 1995, September 1998, and July 2019. Notably, there was no recession in the 12 months after the first two examples, and the Fed cannot be blamed for moving too slowly after the pandemic-related recession began in March 2020 (a justification being put forth today by those who favor a larger rate cut this week).

In this same time frame, the Fed initially cut rates by 0.50% on two occasions: January 2001 (an emergency meeting) and September 2007. In both cases, a recession was underway only months later.

One key takeaway: In “normal times," an initial rate cut of 0.25% is consistent with an economic slowdown, whereas an initial cut of 0.50% typically accompanies a rapidly deteriorating economy. Such is not the case today: the U.S. economy seems be growing at a respectable pace; stock prices are hovering near all-time highs; credit markets are showing few signs of any major stress; and the unemployment rate, while rising, is still at historically low levels. Moreover, although inflation has fallen considerably since the Fed began raising interest rates, it remains above the Fed’s long-term target of 2%.

But perhaps 25 basis points versus 50 basis points really isn’t the question we should be asking. More noteworthy, perhaps, is the following: What happens to asset prices (i.e., stocks and bonds) once the Fed starts lowering interest rates? The answer: It depends.

Looking back even further, starting in the early 1970s, there have been 11 episodes when the Fed started cutting interest rates. [Prior to 1990, the Fed offered little detail about the size of changes in interest rates at a given meeting.]

In this span six times after the Fed started cutting interest rates, the economy fell into a recession. Cash outperformed stocks and bonds outperformed cash. In the other five occurrences when the Fed lowered interest rates, the economy did not enter a recession; stocks outperformed bonds and bonds outperformed cash.

In other words, cash became a less competitive asset class, and while past performance is no guarantee of future results, we think investors today would be wise to revisit their liquidity position and consider reallocating excess cash into high-quality stocks and bonds. “New Tools” such as certain alternative and real asset strategies can further enhance the diversification of a total portfolio.

Importantly, since the COVID-19 pandemic, defining “normal” has proven challenging. Today, with the labor market clearly slowing and real interest rates at 20-year highs, it may be prudent to start with a larger-than-usual rate cut. At the same time, today’s labor market is composed of several unique features because of immigration and work-from-home trends. Moreover, with the economy still awash in liquidity, the Fed should be wary about reigniting an inflationary impulse after working so hard to subdue it. As one astute market watcher noted: “It’s useful to know history, but history guides people astray all the time.”¹

Another key takeaway: Given this, we reaffirm our view that investors should maintain a balanced risk posture by keeping their portfolios in line with their strategic asset allocation targets. We also suggest instituting small tilts to asset classes where valuations are less demanding. Last, whatever the Fed does (or does not do), we continue to believe that those who maintain a long-term horizon, focusing on time in the market versus attempting to time the market, will be best served.