NM economist: Fed likely to cut key interest rate as inflation eases

Things have been pretty expensive over the last couple of years, and the Federal Reserve has raised its key interest rate to help battle inflation over that period.

Raising that rate has also adversely affected car loans and mortgages, which have increased.

But with the job market cooling and inflation easing, the Fed wants to stimulate the economy a bit — planning for what could be the first rate cut to the key interest rate, otherwise known as the Federal Funds Rate, since 2020.

To understand what the Federal Funds Rate is, how it works and what the cutting it can ultimately mean for people here in New Mexico, the Journal asked longtime local economist Kelly O’Donnell a series of questions about the Fed’s Sept. 18 meeting.

Journal: What is the rate that the Federal Reserve either raises or cuts during its meetings?

O’Donnell: The Federal Reserve controls the Federal Funds Rate, which is the interest rate banks pay when lending money to each other overnight. Put simply, the Federal Funds Rate is the cost of money at any given time in the U.S. economy.

The Federal Funds Rate impacts the rate of interest charged on consumer and commercial loans, and thus has a powerful effect on the economy. The Federal Reserve uses the Federal Funds Rate as a tool of monetary policy. Monetary policy is how the Fed seeks to keep the economy in equilibrium — balancing job growth and inflation — to keep the economy growing at a sustainable rate without overheating.

The Federal Funds Rate has an inverse relationship to inflation — a higher federal funds rate puts downward pressure on inflation. The Fed cut rates during COVID-19 to stimulate investment as a way to keep the economy from falling into recession. The Fed began increasing rates when inflation started to spike. Now that inflation appears under control, the Fed is throttling back on interest rates to once again stimulate economic growth.

Journal: What does that rate mean for things like car loans and mortgages?

O’Donnell: The Federal Funds Rate is the rate of interest that banks pay, thus it directly impacts the rates banks charge for loans and the rates they pay as interest on savings accounts.

Consumer interest rates — like those on car loans and credit cards — will go down if the Federal Funds Rate does. Commercial loan rates will also decline. A decrease in commercial rates will stimulate the economy by making it easier for businesses to borrow money to fund growth.

Mortgage interest rates, although not directly tied to the Federal Funds Rate, are also likely to decline when the Federal Funds Rate does. This will stimulate home buying and homebuilding. Homebuilding will be further stimulated by declining commercial interest rates, which will make it less costly for homebuilders to obtain financing.

Journal: What is the likelihood the rate will be cut by the Fed at its meeting on Sept. 18 and why?

O’Donnell: The Fed is highly likely to cut rates this month because inflation appears to be under control and job growth is cooling and unemployment is up, indicating that the higher interest rates of the last couple of years are starting to depress the economy. Rates need to come down in order to stimulate investment and thus growth.

Journal: Based on the Friday, Sept. 6 U.S. jobs report, how much do you think the Fed will slash rates and why?

O’Donnell: Lower-than-expected job growth in August combined with modest downward revisions of the job estimates for June and July support the contention that the Fed has waited too long to start bringing rates back down and, in my opinion, increases the likelihood that rates will be cut by more than a quarter point. If I were a betting person, which I am not, I would put my money on a half-point decrease.

Journal: Can this potential cut help fix housing affordability in New Mexico in the near term?

O’Donnell: Lower mortgage interest rates will make homeownership more affordable, which is definitely a step in the right direction, but far from a solution. New Mexico’s housing crisis, like the national crisis, is the product of under-supply. Homebuilding really slowed after the 2008 subprime crisis, and it never fully rebounded. Building more homes on less land and putting those homes closer to transportation is essential to sustainably reducing the cost of housing.

Journal: This is the first potential cut for the Fed since 2020. (It raised rates nearly a dozen times between March 2022 and July 2023.) Why did it take the Fed so long to cut the Federal Funds Rate?

O’Donnell: The Fed waited a long time to cut rates to be sure that inflation was under control. An uptick in unemployment and slowing job growth reported in early August suggest that they may have waited a bit too long to cut rates and that this has negatively impacted the economy.

Journal: Do you expect more cuts to follow this Sept. 18 meeting? Why?

O’Donnell: Personally, I do. Having waited so long to cut rates, there is now a need to stimulate the economy and get job growth back on track.

Kelly O’Donnell is a longtime New Mexico economist and current chief research and policy officer for Homewise.