Interest Rate Cuts Have Begun.

The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. Well, you heard it folks, that is Jerome Powell, the Chair of the Federal Reserve, talking at Jackson Hole a few weeks back. In that speech, he acknowledged that the time has come for the Fed to start lowering interest rates.

In the United States, currently, the US federal funds rate sits at 5.25 to 5.5%. That's the highest since the turn of the century. But now, with inflation lowering to around 3%, job creation stalling, and unemployment starting to tick up, Jerome Powell and the Federal Open Market Committee have decided that it's time to flip policy and lower rates. This, in turn, starts to take the clamps off the economy. It makes borrowing conditions easier, means mortgage rates come down for homeowners, and people have more money left over at the end of the week to spend on what they like. Ultimately, that's good for businesses, who get a boost in their revenues, and it's generally positive for stock prices.

The Fed will next meet on the 17th and 18th of September, where it is now pretty likely that they will announce an interest rate cut. In fact, turning to the current stock market conditions, Reuters reports that the market is currently pricing in a full percentage point drop to interest rates by the end of this year. So, investors are in agreement, and they are very excited to hear that rates will likely be coming down in the not too distant future.

But, and I don't like being the party pooper, I wanted to make this video because in my non-professional opinion, I think everyone is getting way too excited over this. As you'll see later in the video, I'm far from the only one. So, let's look a little bit deeper into the proposed reversal of monetary policy. Is it actually a smart move for the Fed to begin lowering rates? Well, firstly, let's lay some groundwork and talk about why the Fed is deciding to flip monetary policy.

It comes back to their dual mandate. For those that don't know, the Federal Reserve has two jobs: they work to ensure price stability, aka make sure inflation stays steady, and at the same time, they try to promote maximum employment in America. Now, over the past few years, and really after the initial phase of the pandemic, the promoting maximum employment side of their equation really hasn't been an issue. All eyes have instead been on the massive inflation that we saw, and that was really the trend for a good few years. We basically didn't mention jobs or unemployment because we were all just worrying about inflation.

Now, however, inflation seems to have settled. But for the first time in many years, it's the unemployment side of the equation that the Fed is having to focus more on. A few weeks back, the Bureau of Labor Statistics noted that job additions in the United States had lowered quite substantially versus prior months. If we look at the unemployment rate, it's now risen to 4.3%, which is the highest level we've seen in a good few years. In that speech at Jackson Hole the other week, Jerome Powell said that the Fed is not keen to allow the labor market to worsen any further than it has.

By keeping interest rates up at around 5%, the cooling in labor market conditions is unmistakable. Job gains remain solid but have slowed this year. Labor market conditions are now less tight than just before the pandemic in 2019, a year when inflation ran below 2%. We do not seek or welcome further cooling in labor market conditions. So, it's ultimately the labor market conditions that caused the Fed's decision.

As you've probably seen, this decision to start lowering rates is making a lot of people very excited, and I can understand this excitement; it is a "lifting of the shackles" moment. When interest rates are lowered, in theory, it's a good thing for the economy and for the stock market, but I do think this excitement is overblown. I think it's worth tempering expectations on these proposed rate cuts because, honestly, I don't see them making all that much of a difference.

I think a lot of people, upon hearing the idea that monetary policy has flipped, assume the Fed is going to begin unwinding all of the interest rate rises we've seen over the past few years. You know, we were at 0 to 2%, now at 5.5%, and now the Fed will start to reverse course back to 0 to 2%.

Now, that might be the case, but I think it's very unlikely that the Fed will cut rates by any significant amount over the next few years. I think the reversal on their stance of monetary policy makes for a good headline, but in practice, it simply won't materialize into anything super significant. This is a point that many much smarter people than myself have been discussing over the past few months.

Perhaps none have explained it quite as well as Howard Marks. Rates are likely to be between 2 and 4%, not between 0 and 2%. The Fed funds rate between 0 and 2% is an emergency measure. The Fed funds rate was zero for much of the—probably the majority of the time—in the 2009 to 2021 period, and that's inappropriate. You can't live on a shot of adrenaline every morning for 13 years.

I would like to see a Fed get to a neutral position, which is neither stimulative nor restrictive, and I describe that as 2 to 4%. I think that within two or three years, the Fed funds rate is likely to be in the threes and settle there for the subsequent years, lower than today's 5.25 or 5.5%, but well above the half percent average that prevailed between 2009 and 2021. Ultimately, that low interest rate environment, that stimulative adrenaline environment of the past few decades, is what's causing the situation now to be so painful for a lot of people.

Even from my own experience, it's been really interesting to see how many people buy into the idea that interest rates are simply going to go back to where they were. It's interesting; here in Australia, we don't have those 30-year fixed mortgages like what's available in the US. Generally speaking, homeowners after a few years will go onto a variable rate mortgage, where they are sensitive to interest rate changes.

It's been really interesting hearing even some of my friends who are homeowners saying to me, "You know, I can't wait until interest rates go back to where they were." It's a tough pill to swallow, but I cannot see that happening, and I'll explain why. As Howard Marks says, the 0 to 2% interest rate environment should be an emergency, a stimulative zone.

But over the past few decades, because rates have just been left there, it's felt like those rates are just normal. We have to look at the current environment we're in. Inflation is still stubbornly sticking around 3% as opposed to trending all the way back down to 2%.

On top of that, the labor market conditions, despite weakening slightly now, are really not that bad. As Jerome said himself the other day, historically, unemployment is still really low. So, while it makes sense that rates could start to be lowered now, there's no great need to do so. In fact, with inflation still higher than the target rate, it makes more sense to keep cautiously elevated versus where they were previously.

If you cut too fast or too far, then all you're doing is encouraging inflation to ramp back up again, and that's what happened in the 1970s. It's what the Fed wants to avoid at all costs. That's 0-1.

In a similar vein, another reason I do not believe rates will be cut by a significant amount over the next few years is because Jerome himself has acknowledged that they do want to do what Howard Marks was talking about. The Fed wants to position interest rates so that they can very easily move in either direction if they need to in the future. They want that flexibility because we have to remember right now people are saying we're really suffering with high interest rates, but historically, these are not high interest rates at all.

These are just normal rates. As crazy as that sounds, the rates we're seeing right now are just in a normal range historically. It's just the last few decades that have made this stimulative environment feel normal. I resist the term "higher for longer" because I don't think of rates today as being higher; these are not high rates; these are normal rates. Nevertheless, they're a lot higher than what we lived through in the last 15 years.

In fact, if you're in your 20s or 30s, you should ask your parents what the interest rate was on their first home, their first mortgage, and you'll probably be surprised by the number they tell you. With interest rates in a normal range now, the Fed would prefer to keep them there to give them room to move in either direction if they need to.

If unemployment spikes or the economy suffers, then yeah, they've got sufficient room to lower rates to help out. But if inflation spikes again, then they wouldn't need to raise rates in a drastic manner, like what they've done the last year or two, in order to get inflation back under control.

We think policy is well positioned to handle the risks that we face if higher inflation does persist. We can maintain the current level of restriction for as long as needed. At the same time, we have significant space to ease should the labor market unexpectedly weaken.

That was a snippet from a speech Jerome gave about four months ago. This is a snippet from a speech he gave just a couple of weeks ago: "The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions."

He's essentially telling us that they want to keep interest rates roughly where they are now to give themselves room on either side of the equation—don't necessarily commit to big interest rate cuts if you don't absolutely need to—and rather keep that ammunition for a rainy day.

This line of thinking is exactly what many of the world's best investors were also expecting from the Fed. This is Steve Eisman about four months ago explaining exactly this perspective: "I mean my view is the economy is fine. I personally think there should be no Fed cuts this year. You know the market will do whatever the market does, but the economy is fine. My actual fear is that if the Fed were actually to cut rates, the market goes into some—it becomes, I guess, Bubblicious, and then we have a real problem. So, you know, things are good; the Fed should do nothing and wait for data to get weak because there's no weak data now."

As I said, that clip was from a few months back, and since then, some of the labor market data has worsened, but you get his point right? If inflation is not 100% under control and you're not being forced to lower rates, you probably shouldn't. Ultimately, that's why I do not believe we will see meaningful Fed rate cuts across the next year or two.

Yes, maybe a percentage point or two, but nothing like the low interest rate environments of the past few decades. This may cause some very real economic and market dynamics that investors may not like and should be prepared for.

As Howard Marks is about to explain, "After a long period in which everything was unusually easy in the world of business, finance, and investing, I think something to normalize appears to be setting in. As a consequence, I believe economic growth may be slower, profit margins may be lower, investor psychology may not be as uniformly positive, ownership interest may not appreciate as reliably, the cost of borrowing will not trend down consistently, leverage is unlikely to add as much to results as it did in the period of declining rates, business may not find it as easy or as inexpensive to obtain financing, and default rates may head higher."

So, while I hate being negative, I just think it's worth keeping our heads in check as investors. There's no doubt the market has already responded extremely strongly to inflation calling and the Fed suggesting rate cuts might be on the horizon. Year to date, the S&P 500 is already up roughly 20%.

But I think it's just worth checking our excitement level slightly and maybe modeling for a future where interest rates stay in the 3 or 4% range as opposed to the 0 to 2% range. I mean this is the summary: you know, Einstein said that insanity is doing the same thing over and over and expecting a different result.

I think another version of insanity is doing the same thing in a different environment and expecting the same result. So, if the environment for business and investing is so thoroughly different in the coming 5 or 10 years as it has been in the last 15 to 40 years, I think it's folly to expect the same results.

But with that said, please let me know what you guys think down in the comments section below. Do you think we're in a new era of normal rates, or do you think the Fed will lower rates as low as they realistically can? I'd love to hear from you guys. And lastly, if you're interested in learning how to invest, Quick that New Money Education is the spot to head to.

We've got two amazingly well-produced courses over there and some really great testimonials that I'd encourage you guys to check out. But with that said, thanks very much for watching everyone, and I'll see you all in the next video.