So we expect to reduce the rate. When will we start to see a difference in the economy? | CNN Business

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CNN
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If you’ve been eagerly awaiting monetary relief from the Federal Reserve, you’re in for a rude awakening.

After keeping interest rates at a 23-year high for more than a year, the Fed is expected to announce Wednesday that it is finally cutting its lending rate. And Fed Chairman Jerome Powell may well indicate that there will be more tapering in future meetings.

If that ends, it will be the moment investors spend every second of every hour dreaming of when the central bank starts raising interest rates in March 2022 to reverse inflation. . Don’t be surprised if all their happiness sends stocks to a new record.

But don’t be fooled: Most Americans will have to strain to see much of a difference in one cut, or multiple cuts, for at least a year, if not more.

Central banks cut interest rates for two main reasons: financial conditions are expected to worsen significantly, or inflation is so low that leaving interest rates at high levels will be too difficult and putting the economy into recession. This time, many economists believe that the Fed will cut for the last reason.

When the Fed seeks to relieve pressure throughout the economy, it lowers what is officially called the federal funds rate, which is the interest rate that commercial banks charge each other to ensure they meet their capital requirements. need to set it aside. at all times.

Money lowers its expected rate by buying more securities, such as Treasury notes and mortgage-backed securities. Banks actually get a portion of the money the Fed spends on purchases, leaving them with more money to lend to consumers. When they have more money to borrow, they don’t need to charge such high interest rates on mortgages and other types of loans that they offer.

Although this is one effect that can be seen immediately, it is only the tip of the iceberg. Most of the impact comes much later.

Interest rate levels affect many different decisions that individuals, businesses and governments make.

Simply put: When rates are low, borrowing is cheaper than when rates are high. In the case of the rate cut expected on Wednesday, businesses may decide that it now makes more financial sense to invest in new projects or hire more workers if their small income is tied to paying debts.

Similarly, low interest rates make it more attractive for consumers to spend money, rather than save it, because of the rate they can earn for setting aside money in savings accounts. it comes down. While businesses can respond to rising demand by raising prices, that doesn’t happen immediately after the Fed lowers rates, said Thomas Drechsel, an economics professor at the University of Maryland.

“Think about your Netflix subscription, they’re definitely not going to change it every week or every month,” he said. Put another way, if Netflix sees an increase in the number of new subscriptions after the Fed lowers rates, it won’t be able to respond to the surge in demand by charging higher prices. That’s because, often, businesses are already locked into contracts with their customers that prevent them from changing prices immediately, he said.

When the Fed lowers or raises rates, it takes a while for the full impact of those moves to be felt in the economy. Nobel Prize-winning American economist Milton Friedman referred to this as “long and variable rates.”

“It’s almost the same,” Drechsel told CNN [the Fed is] to steer a great ship, and though they turn the wheel, it takes time to get the ship moving.”

The court still knows exactly how long that period is. Some economists think it will take about a year, which helps explain why inflation started to cool significantly in 2023, a year after the Fed started the process. its climbing. But Drechsel said based on his research it could take “many years until it fully occurs and until the full impact is available in all the data we have on the economy.”

“That doesn’t mean some effects aren’t felt beforehand, but full transmission takes years,” he said. Complicating matters further, it could mean that the effects of the Fed’s first hike are still working their way through the economy, he said.