Will Fed rate cuts translate into a strong U.S. economy?

The U.S. economy appears to have avoided a recession despite one of the sharpest rate hiking cycles ever by the Federal Reserve. Now investors are wondering how strong economic growth will be in 2025.

Thus far, the rebound has been slow and modest, with notable weakness in the manufacturing sector. The Institute for Supply Management’s index of manufacturing conditions remained in contractionary territory at 47.2 as of the end of September.  

As a result, company earnings have been broadly disappointing so far in 2024, with the notable exception of companies benefiting from spending on infrastructure for artificial intelligence applications. 

The housing market will be important

One reason for optimism that the pace of growth will quicken in 2025 is the expectation that interest rate cuts by the Fed will drive economic activity higher as falling interest costs boost spending by U.S. consumers.

However, there has only been minimal improvement in interest costs for U.S. consumers thus far. While interest rates on credit cards and new car loans have fallen, they are only about 50 basis points (a half of a percentage point) below their peak levels (Figure 1).  

More Fed cuts appear likely, so further relief should be on the way. But it will take some time, and the ultimate magnitude of those cuts is still very much in question.

Meanwhile, rates on fixed rate mortgages are about 135 basis points below their peaks. Mortgage rates are perhaps the most important rates to monitor because the housing market has such a heavy impact on U.S. economic activity.

But the current 30-year fixed mortgage rate, 6.4% as of October 22, is still well above rates on most existing mortgages, currently 3.9% on a weighted average basis (Figure 2). This means that many homeowners are unwilling to sell because they would have to pay a much higher mortgage rate to buy another home.

This raises the question of how much lower mortgage rates will need to go in order to have a significant impact on the housing market.

How much lower do rates need to go?

Data from the Federal Housing Finance Agency can help answer this question. Unfortunately, that answer is not very encouraging.

The data suggest it would take a substantial further decline in mortgage rates to make selling financially palatable to most homeowners. As of June 30, only 24.5% of outstanding mortgage loans had rates above 5%, and almost 60% had rates below 4% (Figure 3).    

Conclusion

The bottom line is that the impact of Fed cuts is likely to be much more muted than normal given the limited effect they could have on housing activity.  

This doesn’t mean Fed cuts will have no impact at all, as rate cuts can affect a wide array of financing activity. But the housing market is typically the most direct way for lower interest rates to translate into a stronger economy. As a result, we believe investors should temper their expectations regarding the economic impact of Fed rate cuts in 2025.