Stocks rallied in the immediate aftermath of Friday’s dismal jobs report, with the S&P500 jumping 0.5% to an all-time high of 6,532 when the market opened at 9:30 AM. While this gain faded to a loss by the end of the day, the initial surge can only be rationalized in one way: investors bought stocks in the hope that weak economic data would force the Fed to cut rates more quickly.
This assessment is supported by the fed funds futures market which, on Friday, fully priced in a 25-basis point cut in September and marked up the probability of three such rate cuts this year. However, those rooting for near-term Fed easing should recognize that lower short-term interest rates could weaken rather than strengthen demand. If this is the case, then the odds of even faster Fed easing should rise, with the most obvious implication being a lower US dollar.
Looking Under the Hood at Monetary Stimulus
But why wouldn’t lower interest rates help boost demand?
The answer can be found by looking at five broad avenues by which short-term interest rates might impact demand, namely:
- Income Effects
- Wealth Effects
- Price Effects
- Exchange Rate Effects, and
- Expectations Effects
Income Effects
The first and most important impact of lower interest rates on aggregate demand comes via its impact on household discretionary income - and it is negative.
This can be seen by looking at household interest income and expense separately.
On the income side, as of the end of last year, American households had total financial assets of $125.0 trillion, $14.0 trillion of which were held in time deposits, money market funds and short-term investments1. Assuming that all of these were fully impacted by Fed easing, a sustained decline of 1% in short-term interest rates would reduce annual household income by roughly $140 billion.
On the liability side, households owed $19.4 trillion. However, of this total, $13.4 trillion was in mortgages, roughly 90% of which was in fixed rate mortgages and so would not directly benefit from any rate reduction2. Nor would households likely benefit from a refinancing wave since the majority of today’s outstanding mortgages were likely issued in the 13 years between the Great Financial Crisis and the post-pandemic Fed tightening when the 30-year fixed rate mortgage rate averaged 4.0%. Even if Fed easing caused this rate to fall substantially from its current 6.5%, (and that is a big “if”), it would not be profitable to refinance these mortgages.
Looking at other consumer debt, only $1.3 trillion of the current $5.0 trillion that consumers owe on credit cards, auto loans and student loans is revolving so any reduction in interest rates would yield very modest savings for consumers. Most other personal loans are also carry fixed rates. Consequently, a 1% reduction in interest rates across the board, might reduce consumer annual interest expense by less than $30 billion, having cut interest income by $140 billion.
Wealth Effects
A second transmission mechanism from lower interest rates to aggregate demand is via wealth effects. Lower long-term interest rates should boost asset values and, to the extent that this makes households feel richer, they may be more willing to spend.
There are clearly wealth effects operating in the U.S. economy today. Indeed, the relative strength of high-end goods and services spending probably owes a lot to an almost $60 trillion, or 56%, increase in household net worth that occurred in the six years ending in June 2025.
However, if markets perceive that the Fed is responding to political pressure and that the risk of higher inflation and higher deficits in the long run is growing, even substantially lower short-term interest rates might not lead to much of a reduction in long-term interest rates, undermining the possibility of a significant wealth effects.
Price Effects
And then there are price effects – that is the idea that lower long-term interest rates make it cheaper to borrow and so would spur demand in the interest-sensitive sectors of the economy. There are two problems with this transmission mechanism, however.
First, there just aren’t that many interest sensitive sectors of the economy left. Home-building is, of course, sensitive to mortgage rates. However, home-building currently represents less than 4% of U.S. GDP. Lower auto-loan interest rates might help – but since auto loans have much shorter maturities than mortgages, the impact of lower interest rates on monthly payments is much less.
Capital spending has also become less sensitive to interest rates over the years as the share of non-residential structures has declined and the share of equipment and, especially, intellectual property has grown. These latter areas of capital spending should be much less impacted by lower interest rates than long-lived assets such as structures.
Moreover, all of these impacts depend, as is the case with wealth effects, on declines in short-term interest rates feeding through to lower long-term interest rates.
Exchange Rate Effects
One further transmission mechanism from lower interest rates to aggregate demand is via exchange rates.
We have long believed that the U.S. dollar is overvalued from a fundamental perspective, supported, in part, by high over-night interest rates in the U.S. relative to other developed economies. Lower short-term interest rates should lead to a lower dollar, boosting U.S. exports. The first part of this appeared to be on display on Friday with the DXY dollar index falling 0.4% in reaction to the jobs report. However, exports account for less than 11% of U.S. GDP and, even in the absence of an on-going trade war, it would take a long time for a lower dollar to convince foreign and domestic buyers to switch to U.S. producers.
Expectations Effects
And then there are two broad psychological effects by which Fed easing tends to reduce demand.
The first is simply fear. If the Fed cuts interest rates next week, as we expect, the news media will undoubtedly frame the announcement as a reaction to weak economic data. Worries about recession will be aired and commentators will ask “what does the Fed know that we don’t?” For businesses considering hiring or consumers considering major purchases, the fear of recession could easily engender cold feet.
The second psychological effect is the expectation of further rate cuts to come. For reasons that escape me, the Federal Reserve has, over many years, adopted a gradual approach to changing interest rates when they want to stimulate or suppress demand.
However, their gradualism defeats their purpose. If the Fed cuts by 0.25% next week and explicitly promotes the expectation that there will be further rate cuts to come, do you want to borrow now or do you want to wait and see? The answer is easy for a potential homebuyer or business considering a major expansion. It is when rates have fallen as far as they are likely to go and the expectation is that the Fed’s next move will be to raise rates, that borrowers are truly incentivized to act immediately.
Investment Implications
Of course it wasn’t always this way. There was a time when households received much less interest income than today and much more of spending was interest sensitive. There was also a time when the Fed didn’t so thoroughly telegraph its punches so a rate cut did not so obviously foster expectations of recession and further rate cuts to come. That being said, in the economy of 2025, when you add up income effects, wealth effects, price effects, exchange rate effects and expectations effects, cutting short-term interest rates seems more likely to reduce, rather than increase, aggregate demand.
While all of this deserves much deeper research, the broad argument has a number of interesting implications. It suggests, for one thing, that “R-star”, the interest rate that equates aggregate demand and aggregate supply, may not exist at all and so Fed officials should not reference the idea that current rates are above R-star as a justification for cutting them now.
More importantly, it suggests that once the Fed embarks on renewed easing, it will have to keep going. We expect the economy to weaken further between now and the end of the year and a rate cut this month will not help the situation. This could lead to further rate cuts in October, December and January – although rising inflation pressures and the prospect of fiscal stimulus from income tax refunds could forestall faster easing.
That being said, by the second half of next year, the economy could again begin to lose momentum, even as tariff-induced inflation begins to wane. If that occurs, the Fed may come under pressure to administer further doses of a singularly ineffective medicine.
Such an exercise may not boost either U.S. stocks or bonds if it reflects a worsening economic and fiscal situation. However, it could put further downward pressure on the dollar, suggesting that the most important takeaway from the Fed’s attempts to help the U.S. economy could be to invest in foreign-currency denominated international assets.