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Why the Fed Cut Interest Rates—and What to Watch for Next

It's hard to be surprised when you've been expecting it for months.

After the Federal Reserve's announcement Tuesday that it would lower its basic interest rate by 25 basis points—a 0.25% cut—markets were calm. But then, data from the Fed funds futures market has suggested that for weeks 100% of investors already expected at least that much.

There was no way the Fed would have scuttled a cut. "The risk of a stock market drop would be too high," said Craig Kirsner, president of Stuart Estate Planning Wealth Advisors. Even though economic news in the U.S. has been relatively strong, "you are beholden to the market’s reaction and the Fed can’t disappoint."

Similarly, a 50-basis-point cut seemed unlikely. "Although the first cut in a new cycle historically has been 0.5%, this easily could frighten financial markets about what the Fed knows but isn’t saying," said Steven Skancke, chief economic advisor for Keel Point and former U.S. Treasury and White House National Security Council staff member. "Not that a quarter-point reduction in the Fed Funds rate makes a material difference to borrowers, but it seems to have symbolic importance that the Fed doing something, lest it be blamed for inaction if the economy slows further."

However, chances seem likely that this cut will be followed by at least 0.25% cut "as a measure of safety and insurance," Skancke said.

Some analysts and advisers went gone so far as to wonder why the Fed bothered signaling a cut at all in previous remarks by Fed Chair Jerome Powell. The economy seems to have been moving along well enough.

But that view is short-sighted, said Robert Johnson, chairman and CEO of Economic Index Associates and long-time Fed watcher. "We are operating in a global environment," he said. "When you see interest rates globally that are as low as they are, we have to take that into account." Some central banks have at times over the last few years even set negative interest rates, paying banks to lend them money in an attempt to stimulate their economies.

And a lot of people are depending on the good times to continue, at least for a while "The world has been in a slightly odd place for the past few years," said David Johnson, founding director of foreign exchange specialist Halo Financial. "The U.S. Federal Reserve; historically the central bank that offered the cheapest lending rates for international investors, has actually been offering higher yields than Europe, Australia, Asia, and the U.K. So, when global tensions between the US and China, in the Middle East and over the UK’s EU membership have raised their heads, the movement of funds into US assets was an even easier decision."

"I think there are a lot of unknowns out there," Johnson said. "We don't know the outcome of these trade talks" for example. Trade wars are still unresolved and ongoing. Other national economies aren't necessarily seeing the performance of the U.S. If some begin to falter, that could affect the global economy and hinder things in the U.S.

And so, the Fed took the only path available: moderation between doing nothing and a more aggressive path. That still leaves one clear danger: If there is a major financial contraction, the Fed may no longer have enough working room to provide a rate cut large enough to stimulate the economy back into working order.

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