Notes on the week aheadContributor Dr. David Kelly
Why the Fed shouldn’t cut rates on Wednesday (but probably will)
One of the things we learnt early as parents is the importance of a grocery store strategy. Without it, you can easily end up with a checkout aisle meltdown, as your little angels throw a tantrum over a forbidden candy bar. Sari’s strategy was to allow our sons one “free throw” per visit. You could throw one thing from the regular aisles into the cart but that was it and she held firm at the checkout. The key was to give the kids something but set their expectations as to the limits of our largesse. The Fed could do with a “free throw” strategy today.
On Wednesday, the Federal Reserve will conclude its September policy meeting. Futures’ markets have priced in a high probability that they will cut the federal funds rate by 25 basis points and this is likely what they will do. However, there are at least six good reasons why they shouldn’t:
(1) Economic growth is at its long-term potential pace, with few signs of imminent recession. There are, of course, some negatives in the short-term outlook. Exports are down year-over-year, real business fixed investment looks set to lodge a second consecutive quarterly decline and inventories still look a little high. In addition, housing activity is flat, as should be evident in this week’s Housing Starts and Existing Home Sales releases and light vehicle sales have also plateaued. On the other hand, consumer spending in general appears very healthy and last week’s retail sales report suggested real consumption growth of roughly 3% annualized in the third quarter following an over 4.5% gain in the second.
Job growth is slowing down, but, as is evidenced by a very low unemployment rate and low unemployment claims, the economy is short of workers rather than jobs. So while overall real GDP growth appears to have decelerated to roughly 2% from close to 3% last year, this is in line with the Fed’s 1.9% estimate of the long-term potential growth rate of the U.S. economy.
(2) Inflation, while relatively subdued, appears to be edging up rather than down. Last week’s August CPI report saw core consumer prices rise by 0.3% for a third consecutive month. Core CPI is now up 2.4% year-over-year, which is actually the strongest year-over-year gain since 2008. Of course, the Fed focuses on consumption deflator inflation which runs cooler than the CPI. However, nothing in the CPI report suggests a threat of deflation.
Similarly, wage gains appear to be firming. In August, the wages of all private sector workers were up 0.4% month-over-month and 3.2% year-over-year while the earnings of production and non-supervisory workers rose 0.5% and were up 3.5% relative to a year earlier, tying their fastest year-over-year pace in over a decade.
In short, while other issues, like tariffs, the exchange rate and oil prices can have a large short-term impact on inflation, the underlying trend in inflation is rising rather than falling.
(3) Financial conditions are already very easy. Early this year, the Federal Reserve reversed course, ending a slow but steady increase in short-term interest rates and announced a halt to its reduction in its balance sheet. While lower inflation, an escalating trade war and slower global growth all contributed to this pivot, another important factor was a stock market slump which nearly pushed the S&P500 into bear territory by Christmas Eve. Since then, despite slowing growth and rising trade tensions, the stock market has fully recovered and, as of Friday, the S&P500 stood within 20 points of its all-time high. In addition, despite a backup last week, 10-year Treasury yields remain well below core CPI inflation. Given these numbers, there is little sign that financial conditions are overly tight or any reason that the Fed ought to act to further boost the stock or bond markets.
(4) The Fed needs to save ammunition to fight any future financial panic. One of the key roles of any central bank is to maintain or restore financial stability. In the financial crisis of 2008-2009 it did so through a series of extraordinary financial measures. However, in previous episodes of financial turmoil, such as the 1987 stock market crash or the Asian financial crisis of 1998, it achieved a measure of stability simply through reducing interest rates. At some stage in the future, the Fed will undoubtedly feel the need to do so again. However, with a federal funds rate at just over 2% today, a rate cut on Wednesday, followed potentially by further rate cuts, would limit the ability of the Fed to provide that kind of support when financial markets really needed it.
(5) Artificially low interest rates encourage bad decisions. It is important to recognize that interest rates aren’t just low – they are artificially low, reflecting the aggressive actions of central banks, over and above the impact of slow growth and low inflation. However, an artificially low level of interest rates creates serious distortions because of their impact on decisions made by both the government and private sector.
On the government side, low interest rates have muted criticism of the surging budget deficit, which should come in at just under $1 trillion, or 4.6% of GDP, this fiscal year and over $1 trillion for as far as the eye can see thereafter. These deficits will eventually have to be reduced in a way that will involve pain for both taxpayers and retirees. In addition, interest rate cuts seem to have encouraged the Administration to ramp up a trade war that is doing serious damage to the U.S. and global economies.
On the private-sector side, low interest rates are allowing some corporations to increase leverage more than they should or to overstock inventory. Eventually, business decisions need to make sense in a normal interest rate environment and the longer the Fed maintains an abnormal environment, the greater will be the disruption when interest rates once again reflect economic fundamentals.
(6) Cutting rates from very low levels in today’s U.S. economy doesn’t stimulate aggregate demand, as we outline in an article in our upcoming “Long-Term Capital Market Assumptions”. The reality is that cutting interest rates has always been a mixed bag from an economic perspective. However, over time, a decline in the importance of the manufacturing and housing sectors, the concentration of wealth among a smaller share of households and the competitive actions of other central banks have diminished the positive price, wealth and currency effects of monetary easing. Meanwhile lower rates means less income for savers, as well as tending to undermine confidence and convince many not to borrow until further rate cuts have occurred. In short, if the Fed does cut rates on Wednesday, we will not be marking up our forecasts for economic growth.
None of this will probably be enough to sway the Fed this week. While many of these points will be reflected in a new set of Fed forecasts, the Fed statement and in Jerome Powell’s press conference, the reality is that the markets now expect a rate cut and would react badly to not getting one. In addition, the President would, no doubt, rail against the lack of Federal Reserve cooperation. Jay Powell and other Federal Reserve officials are likely very worried about their ability to maintain the Fed’s independence, and given the unprecedented and very public pressure being exerted on them, they may want to pick their battles.
However, even if the Fed does indeed cut rates this week, they will need to start to reset expectations on further easing. If “data dependent” is to mean anything, the Fed needs to state clearly that the case for further monetary easing has diminished and that investors should not bank on further rate cuts going forward. Such messaging might well elicit a negative reaction from markets and the Administration. But while the Fed may want to pick its battles, just as with kids in the grocery store, surrendering too many battles is akin to losing the war.
Finally, for investors, any messaging that the Fed might pause in rate cuts after Wednesday would obviously be more hawkish than market expectations that are still betting on a cut this week followed by two more by next spring. Such messaging could cause a backup in rates, a rise in the dollar and a fall in the stock market. However, of these effects, only the first should be lasting, as fundamentals, beyond an overly-easy Fed, support a lower dollar and strong stock market for the long run.