The Fed's Powell is cutting interest rates. Here's how the economy will respond.

The U.S. economy survived three years of elevated inflation and high interest rates. Now, the cracks are starting to show.

The Federal Reserve is expected to cut rates Wednesday in a bid to bolster an economy that somehow avoided the recession that many assumed was inevitable when the central bank began to aggressively raise borrowing costs in 2022 to combat surging prices.

Fed Chair Jerome Powell’s next steps will have enormous influence over the economy that either Kamala Harris or Donald Trump will inherit in January. Powell has already telegraphed that he intends to lower rates even more to halt a rise in unemployment that has spooked markets and rattled leaders of both parties.

“Rate cuts going into the end of this year and the beginning of next year will help provide some momentum to the economy,” said Bharat Ramamurti, a former Biden White House official who’s now advising Harris’s campaign. Still, “what job growth is going to look like next year is going to be hard to predict."

The unemployment rate is meaningfully above where it was last year. Rising prices and higher interest rates have put homeownership out of reach for many Americans. A growing number of consumers now expect to miss credit card or auto loan payments. And high rates have slowed the pace of corporate mergers and acquisitions, potentially impeding economic activity.

So far, that hasn’t been enough to push the economy into a slump. But spiking prices have cooled to a point where they’re no longer considered a major economic threat, and investors are betting that Powell will cut rates by as much as half a percentage point at its meeting — double the size of its normal move.

Yet the economy has remained fairly resilient under higher rates, raising questions about how quickly it will respond as rates decline.

“Very sharp and significant Fed rate hikes didn't have the same effect on the economy that you would have expected,” said David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy. “The fact that we didn't have a recession, that the unemployment rate didn't rise very much, makes you wonder: Is somehow the economy less sensitive to interest rates than it once was?”

We’re about to find out. Here is how lower interest rates could affect five key areas of the economy:

A wounded housing market

Residential real estate has been in a rut. High rates, low inventory of available homes, and soaring prices have created significant barriers to purchasing a home — especially for first-time buyers.

“The upcoming Fed rate cuts are helpful, but not a panacea for the housing market,” said Chip Hughey, the managing director of fixed income at Truist.

The Fed reacted to Covid-19 by cutting rates to historic lows, driving down mortgage rates. But unlike previous recessions, consumers emerged from the pandemic flush with cash and ready to spend. That combination was rocket fuel for the housing market.

When rates started to climb, home sales ground to a standstill. The average 30-year fixed rate mortgage peaked above 7.75 percent in the fall of 2023 — the highest in more than two decades — which kept buyers out of the market. Existing home sales fell to generational lows .

Those declines did not lead to a deep reduction in prices, however. What’s more, many homeowners who locked in mortgages at low fixed rates have little incentive to sell: Why pay 6.5 percent on a 30-year mortgage when you’re currently paying 3 percent?

With that said, new and existing home sales both rose in July — a sign that more buyers are entering the market. And as mortgage rates continue to decline, “that should [help with] supply, which would help keep home prices from rising at this torrid pace,” Hughey said.

The jobs market

Concern over the job market is the primary reason the Fed will cut rates.

When inflation was at its peak, unemployment was as low as it had been in decades, and Powell identified the accompanying wage gains as a big reason why prices in service industries were so elevated.

The labor market has softened since then. The jobless rate stands at 4.2 percent, which is low by historical standards but higher than where it stood in mid-2023. The labor force participation rate for workers between the ages of 25 and 54 has expanded. The number of available openings has declined, and it's taking longer for unemployed people to find new jobs.

While the Labor Department’s monthly job reports suggest the labor market is still expanding, it’s happening at a much slower pace.

“A lot of the employment growth that we've got has been kind of more structural in nature, rather than cyclical,” said Aditya Bhave, a managing director and senior U.S. economist at BofA Global Research. Sectors that reported the strongest employment gains in recent quarters — leisure, hospitality, education, health care — had been “battered by the pandemic” and are now experiencing “catch-up effects,” he said.

Lower rates should stimulate hiring, but it may take a while. Cheaper financing makes it easier for businesses to expand and hire more workers. It also provides a lifeline to companies that are struggling to service their existing debt, putting off potential terminations or layoffs. It reduces construction costs for new homes, which should offer more opportunities to building trade workers.

Yet, “just because they're starting to cut now, I don't think you're going to see the benefit in the labor market today,” Bhave said. “Job growth will probably get worse before it gets better.”

Credit card bills

Fed policymakers have been watching consumer spending and credit usage for signs of strain. Lower rates will reduce the cost of maintaining credit card balances, which should provide relief to lower-income households.

Delinquency rates on credit card loans have been increasing for more than a year, and a growing share of households are now paying the minimum due on their balances. Those challenges are particularly acute among those with low and moderate incomes, and more Americans expect they’ll miss a payment than at any point since the pandemic's peak.

Savings rates as a percentage of disposable income have dipped below 3 percent, less than half of where they were at the end of 2019, and more consumers are having to dip into savings, said Gregory Daco, chief economist at EY-Parthenon. “That's simply not sustainable.”

Those challenges have not translated into a material slowdown in consumer spending, but there is evidence that Americans have become more strategic with their purchases. Macy’s CEO Tony Spring described the retailer’s customers as being “more discriminating,” and fast food chains like Wendy’s and McDonald’s are expanding value meal offerings to boost sales.

Given the extent to which credit cards are used for emergency purchases, reduced interest rates on card balances could shift consumer sentiment about the economy.

“When you get hit with a shock, and you can't pay it all out of pocket, that can have a real impact on how you're pursuing the economy,” said Michael Madowitz, the principal economist at the Roosevelt Institute.

Let’s make a deal

The Fed’s decision to keep rates higher for longer has also had implications for large banks and private equity firms. As deal financing costs fall, there’s broad anticipation that it could unleash a wave of mergers and acquisitions.

Deal activity in North America through the first half of the year totaled just $631 billion, well below the $1.3 trillion notched in 2021, according to Boston Consulting Group.

Years of low interest rates created an environment where buyout firms could drive up their companies' valuations using cheap debt. Steeper borrowing costs have made it difficult to find buyers for those companies, and investors are getting antsy about when firms will deliver a return.

There’s a “bloated portfolio of companies in private equity hands right now,” Apollo Global Management co-President Scott Kleinman said at a recent investment conference.

That could change if rates drop and the economy doesn’t fall into a recession. Dealmakers expect M&A activity to accelerate, according to a survey conducted by consulting firm KPMG. Investment banks that depend on deal fees for revenue are also bullish.

“We are in the early innings of a capital markets and M&A recovery,” Goldman Sachs CEO David Solomon told investors during the bank’s second-quarter earnings call this summer.

The stock market

The S&P 500, Dow Jones Industrial Average and Nasdaq all jumped close to their all-time highs when Powell made clear he planned to reduce interest rates at the Fed’s September meeting during a speech in Jackson Hole, Wyoming last month.

Markets will likely have a similar reaction if the Fed lowers borrowing costs on Wednesday.

A Hartford Funds study of 22 previous rate-cutting cycles found that U.S. stocks delivered an average real return of 11 percent in the year after the Fed started cutting interest rates.

The size of the coming rate reduction, along with the subsequent remarks that Powell will deliver about how he views the economy, should provide a glimpse into how much risk Fed policymakers see in this environment.

That could lead to more market volatility leading up to the November presidential election, Kristina Hooper, chief global market strategist at Invesco, wrote in a research note.

Prior to this summer, markets often reacted favorably to soft economic data because it might give the Fed cause to reduce rates. Now that lower rates are imminent, that’s no longer the case, and stock market gains could be muted if it appears the economy is poised to contract.

In other words, “‘bad news’ is no longer ‘good news’ but just plain old ‘bad news,’” Hooper wrote.