DJ Pow’s set kicked off at 2 PM today—and it was historic.

To recap, the Fed hiked rates by 5.25-5.5% from March 2022 to July 2023 in order to curtail inflation. It’s now down to 2.6% from a peak of 9% in July 2022. And with the labor market softening—with unemployment at 4.2% from a recent low of 3.4%—the Fed is now concerned with both sides of their mandate, instead of only inflation, cutting rates by 0.50% today. 

Opposite to market-leanings, we actually expected this first rate cut to instead be 0.25% because:

1. The Fed tends to start with 25 bps as its first move.

2. Inflation is not gone and it would be bad for the market, and the economy, if they had to increase rates again, due to inflation (like what kept happening in the 1970s).

3. The economy is not showing enough weakness, in an absolute sense, in the broad labor market or in GDP growth. 

Will they continue cutting? Yes. In fact, I believe rates could fall to 3.5% by the middle of 2025—not too far from the Fed’s own projections. This should provide support to the economy and labor market by making borrowing (loans, credit cards, mortgages) less expensive. But it also means cash in savings and other yielding accounts will likely also earn a lower rate.

In relation to the Fed and their interest rate policy, the words “soft landing” gets thrown around a lot these days. Because it’s at the core of the debate on how much they should cut rates. If we’re in a soft landing (I think so for now), then they need to maintain a balanced approach to interest rate policy. If we’re not (harder landing), then the Fed will need to act swiftly and cut rates further, faster.

First, a soft landing is characterized by a sustained economic expansion after notable monetary tightening (aka rate increases). And it is uncommon. This is because the Fed usually increases rates to curtail growth, which leads to a drop in actual growth to a recessionary level,  causing the Fed to cut rates to help stimulate growth. And so on. 

The Fed has pulled off this balancing act of a soft landing really only 3 times since 1960: 1964-66, 1983-84, and 1994-95. In the 1960s, the expansion lasted 3 years beyond the Fed's tightening, while in the 1980s and 1990s, the economy continued to expand for more than 5 years. 

These previous soft landing episodes had 2 important features: 

• None generated labor market slack or reduced wage pressures. Rather than cutting costs on labor, firms initially absorbed some of the impact of monetary tightening by accepting a margin compression. We’ve seen this happen this year where margins came hugely into focus as companies disappointed expectations.

• The Fed also quickly reversed course with each episode, reducing interest rates within 6 months of the final hike, as evidenced in these charts:

This calibration away from restrictive stances, combined with other positive growth impulses, boosted demand and bolstered business confidence, extending the economic expansion. It’s been more than 6 months since the last hike, but we’ve had stimulus from other fiscal sources (like the CHIPs Act and Inflation Reduction Act) that have helped growth. This week’s rate cut marks the first step toward continuing an economic expansion, but the real magic happens when demand picks up and corporate margins improve post Fed cuts.

Is AI the answer to sustained economic growth?  While the Fed plays a vital role in stabilizing the economy, its efforts to maintain price stability often curb growth. That is, unless innovation steps in to give productivity a boost. This is precisely what happened in the 1990s with the technology boom—a surge in productivity allowed the economy to grow without stoking inflation and triggering further rate hikes.

We may be experiencing a similar scenario today, thanks in part to AI. Companies have already invested billions of dollars into technologies, such as AI—as evident in the rise in share of intellectual property and research and development spending components of GDP. And there's more on the way.

But making investments is only part of the solution. While we all have stories about how tools, such as ChatGPT have made our lives easier. The real question is when will these advances reduce business costs and drive productivity growth on a massive scale.  

While the Fed's soft landing is an encouraging sign, we still have risks to consider. Smaller companies, burdened by debt refinancing at higher costs, remain vulnerable. While larger firms are better equipped to handle economic headwinds. The future of expansion will likely hinge on productivity gains from technological advances and relief from wage inflation—but the timing is key.