Editor’s Note: Wall Street is euphoric that the Federal Reserve has finally cut its benchmark federal funds rate. But as I explain below, prudent investors should curb their enthusiasm. Here’s why you can’t assume rates will continue falling.

The Federal Open Market Committee (FOMC), the decision-making committee of the Federal Reserve, cut the federal funds rate by 50 basis points (half a percentage point) in mid-September.

This is a big deal because the federal funds rate serves as the benchmark for important interest rates in real life.

High inflation since the pandemic had caused the Fed to increase the rate from zero to over 5% in recent years. This was the first cut since 2020.

All things equal, lower interest rates are a positive for the stock market and higher interest rates are bad.

Interest Rates a Big Deal

When interest rates are high, alternatives to equity, such as Treasury securities, pay a higher interest rate. Since U.S. government debt is regarded as “riskless” (whether we agree or not is another story), this means that you could get a relatively high return for not taking on risk. In other words, if you hold the security to maturity, you know you will get back the face value of the bond. This makes stocks, which are considered riskier due to the high variability of returns, less attractive.

Additionally, higher interest rates mean the cost of debt and financing is more expensive. When businesses make investments, often they need to borrow money because either they don’t have the necessary cash on hand or if they need to use cash elsewhere.

The same can be said for most individuals and families who have to spend on a big item. Imagine if you cannot take out a mortgage to buy a house. Very few Americans would be able to afford a house. Thus, when financing costs go up, it tends to reduce business and household spending alike.

And when business activity is low, that usually means sales and earnings growth aren’t good either, and the economy could end up in a recession. That’s not good for the stock market.

Although the financial system doesn’t have the best of reputations—who doesn’t remember the Financial Crisis?—it is a critical part of our economy. Operating a business is already hard, and it gets even harder without access to the financial system, such as banks.

When There’s No Access to Banking

Just look at marijuana companies. Due to federal regulations, banks are at risk of punishment if they provide service to such companies even if cannabis is legal at the state level. As a result, marijuana companies have to conduct business in cash, and that’s inefficient and potentially unsafe. They also do not have access to financing through proper banking channels, and raising capital legally is tougher than for regular companies.

Fortunately, some relief may be on the way. Besides ongoing work in Congress toward federal legalization and classifying cannabis as a less dangerous substance, there’s also a bill called the SAFER Banking Act that is intended to allow banks to provide banking services to state-sanctioned marijuana businesses. If those companies can access normal banking services, it will make running a business easier.

Don’t Assume Rates Will Keep Falling

The bottom line is, lower interest rates encourage spending and makes stocks more appealing. This is why investors need to pay close attention to inflation trends.

High inflation puts pressure on Fed officials to raise rates. Recently, lower inflation readings have allowed the Fed to pull the trigger on the rate cut. However, if inflation picks up again, it could force Fed officials to go the other way again.

For example, the Middle East, important for its oil but always a hotbed for geopolitical tension, is inching closer to all-out war as the ongoing conflict between Israel and its Arab neighbors is escalating. We saw what supply disruption can mean for inflation when Russia invaded Ukraine.

If war expands to the point of disrupting the Middle East’s oil supply, it would likely bring about another bout of high inflation and force the Fed to reverse course. Therefore, it’s important not to be complacent just because the Fed has just cut rates. Stay vigilant.

Read This Story: How to Beat Wall Street…Under All Investing Conditions

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