Fed’s Looming Rate Cuts Could Impact Corporate America Amid Delayed Reaction to Tightening

Between early 2022 and mid-2023, the Federal Reserve executed one of its most aggressive monetary tightening cycles since the early 1980s. The central bank raised America’s policy interest rate from a near-zero range of 0-0.25% to a robust 5.25-5%. As the Federal Reserve prepares for its next policy meeting on September 17th and 18th, there is considerable speculation that the central bank may begin to cut rates, potentially starting with a significant 0.5-percentage-point reduction in response to cooler-than-expected economic data.

The Lag Effect and Its Impact on Corporate Borrowers

Despite the anticipated rate cuts, the immediate impact may be subdued. Historically, central bankers have recognized that monetary policy changes do not affect the economy instantaneously. Economist Milton Friedman famously described this delay as “long and variable.” However, the current cycle has shown an even more prolonged lag for corporate borrowers than in previous instances. As the Fed prepares to reduce rates, some segments of the economy are experiencing tighter financial conditions than expected.

Unusual Outcomes of the Current Tightening Cycle

In past periods of monetary tightening, there was a clear relationship between rising policy rates and increased corporate interest payments. For instance, during the previous Fed hiking cycle from 2016 to 2019, companies’ net interest expenses grew by 9%, reflecting the typical impact of higher borrowing costs. This increase in expenses is intended to slow corporate investment and hiring, ultimately reducing demand and easing inflationary pressures.

This time, however, the scenario has been markedly different. Despite the surge in interest rates, companies’ net interest payments have actually decreased by almost 35%. In contrast, if the historical pattern had held, these payments would have risen by approximately 50%.

Reasons Behind the Unexpected Trends

Several factors explain this atypical outcome:

1. High Corporate Cash Reserves: American firms entered this tightening cycle with unusually high cash reserves. Cash holdings, which averaged $1.1 trillion in the decade leading up to 2019, surged to $2.7 trillion by 2021 as the pandemic halted investment plans. Consequently, higher interest rates have led to greater returns on these substantial cash reserves.
2. Lender Behavior: Even as policy rates climbed, many lenders were slow to pass on the higher costs to borrowers. For example, the spread charged on loans to the safest borrowers fell by over 1.5 percentage points between early 2022 and mid-2023. The Kansas City Fed noted this as unusual since spreads typically widen during a tightening cycle. Corporate cash reserves appear to have encouraged lenders to be more generous with their terms.
3. Borrowing Practices: Many American companies secured long-term loans during 2020 and 2021, when rates were low and before the tightening cycle began. This strategic borrowing insulated firms from immediate rate hikes. The strong performance of the S&P 500 index, which has risen by 24% since the Fed started raising rates, may partly reflect this protection.

The Imminent Refinancing Challenge

As fixed-rate arrangements begin to expire, the landscape is changing. Fixed-rate loans generally last between three to five years. By the end of 2027, over $2.5 trillion in fixed-term corporate loans, equivalent to 9% of American GDP, will need refinancing. Notably, $700 billion is due in 2025, and over $1 trillion in 2026. Sectors that benefited most from low rates, such as manufacturing, are particularly vulnerable to refinancing risk. For example, bonds of typical non-financial, BBB-rated firms expiring in 2025 have a median interest rate of 3.8%, but future reissuance could see rates closer to 6%.

Future Outlook and Fed’s Dilemma

Federal Reserve Chair Jerome Powell has indicated support for cheaper borrowing costs. However, regardless of the Fed’s actions, corporate America is poised to face increased interest expenses. The delayed response to tightening poses a significant challenge for the Fed, as policymakers are ready to ease rates while many firms are still feeling the effects of past rate hikes. This complex dynamic will continue to shape the economic landscape in the coming months.