The Federal Reserve is expected to launch a rate cut after this Wednesday's FOMC meeting. The Wall Street Journal article on Monday stated that this rate cut was initiated in the condition of the relatively good state of the USA economy, and over time, the rate cut is expected to affect areas such as credit cards, mortgages, and savings. However, there is uncertainty about how these effects will specifically transmit to various areas and what specific effects will result, presenting a complex situation that the Fed needs to address.

Unprecedented rate cut under the relatively good economy

The article states that the rate cut mechanism has always been clear, with the interest on borrowers' debt decreasing and cash returns for savers reduced. But these are just macro-level generalizations, and the specific operational methods remain a mystery.

Moreover, every rate cut cycle is different, and the economic response is both lengthy and unpredictable. Nobel Prize-winning economist Milton Friedman, in a speech to the U.S. Congress in 1959, likened the change in Fed policy to "a faucet, you turn the faucet on now, and the water doesn't flow out until 6 months, 9 months, 12 months, 16 months later."

The rate cut under the current circumstances has no clear precedent in US history. Usually, serious problems have already occurred in the economy before the Fed begins cutting rates. But this is not the case now, as the US labor market, while cooling off somewhat, is still performing well, and the economy has been steadily growing.

In fact, the current economic situation in the USA is even better than it was in 1995, a year which can be said to be a classic example of the Fed's successful achievement of a "soft landing". Back then, inflation declined while the unemployment rate did not rise significantly.

Analysts believe that this may lead to an unusually different economic reaction from the Fed after the rate cut on Wednesday.

For example, because the Fed's rate cut is not an attempt to reverse sharply deteriorating economic conditions, and people are not generally worried about imminent job loss, lower rates may quickly drive spending. On the other hand, the valuation of stocks and other assets remains at relatively high levels, so it is unclear whether the rate cut can provide more impetus.

There are still restrictions on interest rates after the initial rate cut.

The Fed cannot control all interest rates, it can use policy tools to lower short-term rates for interbank overnight loans. After the Fed's rate cut, banks will then lower the benchmark interest rate, which is an important reference for credit card debt and other loans. Long-term rates, such as mortgage rates, also tend to decrease.

In order to curb inflation, the Fed has raised interest rates 11 times since early 2022, raising the target rate from near 0% to about 5.4%. The same logic applies to rate cuts, which means that it takes far more than one or two rate cuts for households and businesses to truly feel the change. It is currently expected that the Fed will cut rates by 0.25% or 0.5% this week.

Analysts believe that even after the initial rate cut on Wednesday, interest rates may still remain at restrictive levels. Three models maintained by the Atlanta Fed show that the level of rates that will not stimulate or slow down the economy is between 3.5% and 4.8%.

Even so, the rate cut will still make life a little easier for some borrowers. Credit card rates closely follow the Fed's overnight target rate, so these rates are expected to drop slightly. Small businesses using floating rate loans will also see a reduction in their interest payments.

The impact on the real estate market is still unknown.

Wednesday's rate cut is likely just the beginning of a series of cuts. The futures market indicates that investors believe the Fed will cut rates by a total of 1.25% by the end of this year and another 1.25% in 2025.

The Federal Reserve sets short-term interest rates, but the biggest impact on long-term interest rates is investors' expectations of the Fed's future actions. In other words, the effect of a rate cut often becomes apparent before the rate cut actually takes place.

This is reflected in the 10-year US Treasury bond yield, which has now fallen to 3.65%. This is a full percentage point lower than in April, and significantly lower than the 5% in October last year.

The 10-year US Treasury bond yield has a significant impact on mortgage rates. According to Freddie Mac's data, the average interest rate for a 30-year mortgage has dropped to 6.20%, compared to 7.22% at the beginning of May this year.

However, it is not yet clear at what level mortgage rates need to fall in order to reinvigorate the real estate industry. House prices remain high, making it difficult for many first-time buyers to enter the market.

In recent weeks, there have been signs of a new increase in mortgage loan applications for home purchases. However, compared to the situation when mortgage rates first dropped below 7% last year, the application volume is still low, reflecting the significance of the "whole number effect" of interest rates. Some analysts predict that if mortgage rates drop to below 6%, or even below 5.5%, there may be another surge in housing demand.

The direction of mortgage rates not only depends on changes in the US Treasury bond yield. Many analysts believe that even if the 10-year US Treasury bond yield remains unchanged, mortgage rates may still decrease slightly. A key component of mortgage rates is the additional spread that lenders charge above the long-term US Treasury bond yield. Historically, a decrease in short-term interest rates often brings mortgage rates closer to the 10-year government bond yield.

Expected to boost corporate equipment investment.

In addition, another area that could potentially receive a boost after a rate cut is investment in equipment by businesses, covering all equipment from tractors to computers.

Currently, the cost of borrowing from the market through corporate bonds for large companies has declined, but the interest rates for small businesses relying on credit card loans remain high. However, with the reduction in interest rates by the Federal Reserve, these rates are expected to decrease.

Typically, lower interest rates take time to translate into faster investment growth. However, analysts believe that a current variable is the particularly sluggish spending on equipment by businesses. According to data from the U.S. Department of Commerce, adjusted for inflation, since the end of 2019, business spending on equipment has only grown by 5.3%, while the overall U.S. GDP has grown by 9.4%.

Dan McManamon, Chief Financial Officer of Ohio Machinery, says that his company has postponed spending on equipment, such as service trucks and tools. Customers have done the same.

"Some people say they will make a purchase, but they are just waiting," he said. "When the interest rate cut happens, we may have our marketing department seize this opportunity."

Interest rate cuts also have other indirect effects.

One of the ways is through the foreign exchange market. When U.S. interest rates decrease relative to other countries, it often weakens the U.S. dollar. This in turn makes U.S. products cheaper and therefore more competitive. However, this impact may be weakened by the fact that many other central banks are also lowering interest rates.

Another impact is the rise in asset prices, which is a common consequence of interest rate cuts. Higher stock prices can make it easier for companies to raise funds and give management more confidence to approve projects. Those who own stocks may increase their spending because they feel wealthier, although many economists believe that the importance of this so-called wealth effect is not as strong as it used to be.

In addition, the direction of interest rates is more important than the level. Both households and businesses may simply feel better knowing that the Federal Reserve has already lowered interest rates and is likely to continue doing so. This alone could reduce the likelihood of an economic recession.

Editor/Lambor