The Fed Cut Rates: So Why Are Borrowing Costs Still Rising?
Understanding the Employment Situation Report and Its Implications
On August 2nd, 2024, the July Employment Situation Report painted a telling picture of the U.S. labor market. Among its key findings was a rise in the unemployment rate to 4.3%, the highest since October 2021. For context, the unemployment rate is calculated by dividing the total number of unemployed individuals (those actively looking for work but currently without a job) by the labor force (a combination of employed and unemployed individuals). While 4.3% might seem like a small number, it represents millions of Americans who are currently unable to secure employment. But what does this data mean for everyday life and your finances? And how does it connect to interest rates and borrowing costs?
What Rising Unemployment Tells Us
Rising unemployment can signal trouble in the economy. When people lose their jobs, it means less money circulating in the economy as households cut back on spending. Imagine a local coffee shop where half the regular customers lose their jobs; suddenly, that shop sells fewer lattes, struggles to pay its workers, and might even close its doors. This ripple effect can stretch across industries, leading to slower economic growth. However, this does not necessarily mean the economy is in freefall. The 4.3% rate is still relatively low by historical standards. It is close to what economists consider "full employment" (typically between 4% and 5%). It is a sign that the labor market remains resilient while challenges are present.
The Sahm Rule and What It Means for the Economy
A key development in the July Employment Situation Report was triggering a well-known recession indicator: the Sahm Rule. This rule, developed by economist Claudia Sahm, acts as an early warning system for economic downturns. It is triggered when the three-month moving average of the unemployment rate rises by at least 0.5 percentage points compared to its lowest three-month average in the previous 12 months. In July 2024, this exact scenario unfolded. The three-month moving average of the unemployment rate rose by 0.53 percentage points above its lowest point since July 2023, officially setting off the Sahm Rule and raising widespread concerns about the possibility of a recession.
What Is the Sahm Rule, and Why Is It Important?
Please think of the Sahm Rule like a car's check engine light; it does not mean the vehicle is about to break down, but it is a strong signal to pay attention. Historically, the Sahm Rule has been triggered before or during every one of the nine recessions the U.S. has experienced since 1960. While it is not a guarantee of an impending recession, it is a red flag that economic conditions may be deteriorating.
To put it into perspective:
Imagine your household income suddenly drops by 10%. You might not feel the effects immediately if you have savings. Still, over time, your ability to cover bills, groceries, and other essentials starts to weaken. Similarly, when unemployment rises, it may not cause immediate economic chaos. Still, it signals a potential slowdown as fewer people have income to spend.
Why This Matters to Borrowing Costs
The activation of the Sahm Rule adds another layer of complexity to the Federal Reserve's actions. While the Fed has cut rates to stimulate economic activity, the lingering fear of a recession creates uncertainty. Lenders may tighten their criteria for approving loans, keeping borrowing costs high for individuals and businesses alike.
The Federal Reserve Takes Action: A 50-Basis Point Rate Cut
As recession fears intensified and cracks began to form in the labor market, many economists, analysts, and investors predicted that the Federal Reserve would pivot from its contractionary monetary stance. This speculation stemmed from the growing need to stimulate the slowing economy and counteract the rising unemployment rate. True to these expectations, the Federal Reserve announced a significant policy shift at its September 2024 meeting, marking its first rate cut since 2020. The central bank reduced the Federal Funds Target Rate by 50 basis points, lowering it from a range of 5.25–5.50% to 4.75–5.00%. This move signaled the Fed's intent to provide relief to the economy by making borrowing cheaper for businesses and consumers alike.
What Does a "50-Basis Point" Cut Mean?
To clarify, a basis point is a unit of measurement for interest rates, where 1 basis point equals 0.01%. So, a 50-basis point cut means the Fed lowered rates by 0.50%, a notable reduction in the cost of borrowing. While this might sound small, even a half-percent change can have a significant impact on financial markets, business decisions, and household budgets. Imagine you are buying a home with a $300,000 mortgage. A 0.50% reduction in your interest rate could save you hundreds of dollars yearly on your monthly payments. For businesses taking out millions in loans, the savings are even more substantial, potentially freeing up funds for investments and hiring.
Why Did the Fed Act Now?
The Fed's decision reflects its dual mandate:
To keep inflation under control (around 2%).
To maintain maximum employment (an unemployment rate below 5%).
With inflation easing closer to the Fed's target and the labor market showing signs of stress, the central bank acted preemptively to stabilize the economy. By lowering rates, the Fed aims to encourage spending, borrowing, and investment, all of which can help cushion the economy against a potential downturn. But despite this rate cut, many borrowers are still seeing high borrowing costs.
The Unexpected Rise in Borrowing Costs Following a Rate Cut
When the Federal Reserve announced its 50-basis point rate cut in September, many consumers and businesses anticipated that borrowing costs across various credit products, such as mortgages, auto loans, and credit cards, would follow suit and decline. And for a brief moment, they did. For instance, the average interest rate on a 30-year mortgage fell sharply, dropping from 6.5% in the month leading up to the Fed's decision to 6.1% the day after the September 19th announcement. This decline reflected optimism that lower rates would ease borrowing costs and support the economy. However, the relief was short-lived. By the following month, mortgage rates had climbed back to 6.5%, leaving many borrowers wondering why the expected downward trend did not stick.
Why Did Borrowing Costs Rise Again?
The culprit lies in inflation data and bond market dynamics. Shortly after the Fed's rate cut, hotter-than-expected inflation reports indicated that price pressures in the economy had not eased as much as anticipated. These reports caused yields on long-term bonds, which heavily influence mortgage rates and other long-term credit products, to rise. To explain this, consider how mortgages and other long-term loans are priced. Lenders often base their interest rates on the yields of long-term government bonds, like the 10-year Treasury note. When bond yields rise, so do mortgage rates as lenders adjust to maintain profitability. In this case, fears of persistent inflation pushed bond yields higher, offsetting the Fed's efforts to lower borrowing costs through its rate cut.
A Closer Look at the Mortgage Market
Imagine you are planning to buy a home. When the Fed cut rates in September, you might have felt encouraged to lock in a mortgage at a lower interest rate. However, as inflation concerns emerged, lenders raised their rates to compensate for the risk of future price increases. This increase meant that, despite the Fed's efforts to make borrowing cheaper, the actual cost of taking out a loan became more expensive for many consumers. This example underscores an important point: While the Federal Reserve has significant influence over short-term interest rates, other factors, such as inflation and market expectations, play a significant role in determining the cost of long-term borrowing products.
Understanding the Link Between Fed Rate Cuts and Rising Borrowing Costs: The Role of the Treasury Yield Curve
The question many are asking is simple: If the Federal Reserve cut interest rates, why are interest rates on specific debt instruments, like mortgages, still rising? The answer lies in understanding a crucial component of the financial system: the Treasury Yield Curve.
What Is the Treasury Yield Curve?
Think of the federal government as a borrower. The government issues Treasury bonds through the Treasury Department to fund its operations. These bonds are essentially loans from investors to the government, with a promise to repay the amount borrowed (the principal) along with periodic interest payments. Treasury bonds come with a variety of maturities, ranging from as short as one month to as long as 30 years. The Treasury Yield Curve is a graphical representation that shows the interest rates (or yields) on these bonds, organized by their length of maturity.
For example:
A one-month Treasury bond might offer a yield of 4%, reflecting the return investors receive for lending money to the government for a short period.
A 10-year Treasury bond might offer a yield of 5%, reflecting the return for a longer-term loan.
A 30-year Treasury bond might offer a yield of 5.2%, providing a slightly higher return to compensate for the extended maturity.
When these yields are plotted on a graph, the result is the Treasury Yield Curve, which gives a snapshot of how much it costs the government to borrow money over different time horizons.
How Does the Yield Curve Impact Borrowing Costs for You?
Here is where the connection to your finances comes in. The interest rates on long-term debt instruments like mortgages are closely tied to the yields on long-term Treasury bonds, such as the 10-year Treasury note. Why? Because lenders, like banks and mortgage companies, use Treasury bonds as a benchmark. When the yield on the 10-year Treasury rises, lenders typically raise their mortgage rates to maintain their profit margins. Conversely, when Treasury yields fall, mortgage rates often follow suit.
Why Did Mortgage Rates Rise After the Fed's Rate Cut?
Although the Federal Reserve lowered the Federal Funds Rate (which influences short-term borrowing costs), this action does not directly control long-term rates. Instead, long-term rates are influenced by factors such as:
Inflation Expectations: If investors believe inflation will remain high, they demand higher yields on long-term bonds to protect their returns.
Supply and Demand for Bonds: When inflation concerns rise, fewer investors are willing to buy long-term bonds, causing yields to increase.
Following the Fed's rate cut, hotter-than-expected inflation data caused long-term bond yields to rise sharply. This pushed up mortgage rates despite the Fed's efforts to lower borrowing costs.
An Everyday Example
Imagine you are trying to buy a car, and your bank sets its loan rates based on the cost of gas. If gas prices are expected to rise sharply, the bank may charge you more interest to offset future risks. Similarly, when inflation expectations rise, lenders increase rates on products like mortgages, even if the Fed is trying to make borrowing cheaper.
Understanding the Treasury Yield Curve and its impact on borrowing costs can help you better navigate these financial shifts.
Short-Term vs. Long-Term Bond Yields: Understanding the Drivers Behind Interest Rate Movements
While the Treasury Yield Curve helps explain how interest rates on various debt instruments are set, it is important to distinguish between short-term and long-term bond yields, as different factors influence them. This distinction is key to understanding why certain borrowing costs, like credit card rates, behave differently from fixed-rate mortgages.
What Drives Short-Term Bond Yields?
Short-term bond yields are closely tied to the Federal Reserve's monetary policy and reflect expectations of changes in the Federal Funds Target Rate.
For example:
When the Fed is expected to cut rates, yields on shorter-maturity bonds tend to fall because borrowing costs for banks decrease.
Conversely, when the Fed is expected to raise rates, shorter-maturity bond yields usually rise as banks anticipate higher borrowing costs.
Short-term yields have a direct impact on credit instruments like:
Credit cards
Adjustable-rate mortgages
Money market securities
Revolving lines of credit
If you have noticed fluctuations in the interest rates for these products, it is likely due to shifting expectations around Fed policy.
What Drives Long-Term Bond Yields?
In contrast, long-term bond yields are less influenced by the Fed's immediate actions and more by expectations of future inflation and economic growth.
For instance:
When investors believe inflation or economic growth will rise in the future, yields on longer-maturity bonds increase to compensate for the higher risk of holding money for an extended period.
If inflation or economic growth is expected to cool, long-term bond yields decline, reflecting reduced risk.
These yields influence borrowing costs for longer-term credit instruments, such as:
Fixed-rate mortgages
Student loans
Longer-term auto loans
This dynamic explains why the Fed's recent rate cuts may not have translated into lower costs for long-term borrowing products, as inflation expectations have been rising.
What is Happening Now?
The recent rise in interest rates on longer-term loans, despite the Fed's rate cut, can be attributed to three main factors:
Rising Inflation: Inflation figures have been ticking upward, particularly due to continued pressures in the housing market. Higher inflation signals greater risk for lenders, prompting them to increase rates.
Cooling Recession Fears: While the Sahm Rule initially raised concerns of a recession, layoffs across the U.S. have remained below historical averages, suggesting the labor market is stabilizing. This has reduced the urgency for rate cuts.
Trade Policy Effects: Future inflation expectations have risen in response to trade policies, such as tariffs, often referred to as the "Trump Trade." These policies create additional upward pressure on inflation, causing longer-term yields and, by extension, borrowing costs to increase.
Why This Matters for Borrowers
Understanding these distinctions helps clarify why your credit card interest rate might behave differently than your mortgage rate or student loan rate. Shorter-term products reflect the Fed's immediate rate actions. In contrast, longer-term products respond to broader economic factors like inflation and growth expectations.
Conclusion: Understanding the Complex Dynamics of Interest Rates
The recent rise in interest rates on certain credit instruments, even as the Federal Reserve cuts its target Federal Funds Rate, showcases the intricate interplay between monetary policy, the Treasury Yield Curve, and market expectations. While shorter-term interest rates closely follow the Fed's actions, longer-term rates are shaped by broader factors, including expectations of future inflation and economic growth. Persistent inflationary pressures, a surprisingly stable labor market, and reduced recession risks have all contributed to rising yields on longer-maturity bonds. These higher yields, in turn, drive up borrowing costs for products like fixed-rate mortgages and student loans, even when the Fed is actively lowering rates to stimulate the economy.
Why This Matters to You
Understanding these dynamics is essential for making informed financial decisions. It explains why your credit card interest rate might drop while your mortgage rate rises, even though both are influenced by interest rate policy. By recognizing how different parts of the Treasury Yield Curve impact borrowing costs, you can better navigate today's economic landscape and plan your financial strategy effectively. Whether you are considering a home purchase, exploring refinancing options, or evaluating long-term financial goals, staying informed about these trends can help you anticipate changes in borrowing costs. Knowledge is power, and in a complex economic environment, understanding the nuances of monetary policy and its ripple effects can empower you to make decisions for your financial future.
Stay tuned for more insights into how economic trends affect your finances, and explore ways to optimize your borrowing and investment strategies in this evolving environment.