Amidst market anticipation, the Federal Reserve has finally cut interest rates. On September 18th, the Fed announced a 50 basis point reduction, officially initiating a cycle of rate cuts for the US dollar.
Chairman Powell had been hinting at this move since the end of last year, suggesting that he would begin considering rate cuts. Throughout this year, market discussions revolved around the timing and magnitude of these cuts. Finally, in September, he made his move.
Today, let's delve into the reasoning behind the Fed's decision to cut rates, the potential extent and duration of these cuts, the anticipated market reactions, and the responses of other central banks.
A Disclaimer Before We Begin
Before diving into the analysis, it's important to clarify that I am not an economist nor am I here to offer radical opinions or conspiracy theories. This discussion will be based on professional and reliable perspectives. Of course, I welcome any thoughts or comments you may have.
What Exactly is the Fed Cutting?
The interest rate being adjusted by the Fed is the Federal Funds Rate, essentially the overnight risk-free interest rate. By controlling this rate, the central bank indirectly influences all other interest rates, including those for one-year, ten-year, and thirty-year loans, as well as deposit rates, mortgage rates, and government bond yields. The market itself determines these rates based on various factors.
How Much and How Fast Will Rates Be Cut?
Current market expectations, as reflected in the options market, suggest that the Fed will complete its rate cut cycle within a year. This would involve a significant reduction from the previous 5.25% to around 2.75%. This translates to an anticipated rate cut of over 200 basis points within a year.
Why Such a Significant Cut?
To understand the rationale behind a potential 200+ basis point cut within a year, we need to step into the shoes of Fed Chair Jerome Powell.
Behind the numerous research reports and speeches delivered by the Fed, which seem to cover everything from banking to savings rates and housing, lie two primary objectives: price stability and full employment.
The Fed's Dual Mandate
As we discussed in our previous video about the Fed, their "mandate" revolves around maintaining price stability and ensuring full employment. The primary tool at their disposal to achieve these goals is the interest rate.
Lowering interest rates stimulates both prices and employment, leading to higher inflation and lower unemployment rates. Conversely, raising rates curbs inflation but can contribute to higher unemployment. Achieving a balance between these two objectives can be challenging.
Ideally, the Fed prefers a scenario where inflation and unemployment are at different levels, making it easier to adjust interest rates accordingly. For example, a situation with high inflation and low unemployment calls for rate hikes, while the opposite scenario necessitates rate cuts.
However, difficulties arise when both inflation and unemployment are high, a situation known as "stagflation." In such cases, it becomes tricky to decide whether to raise or lower rates, as addressing one issue often exacerbates the other.
This inherent conflict between price stability and full employment is why many central banks, like the European Central Bank, the Bank of England, and the Bank of Japan, prioritize price stability as their primary objective, with unemployment taking a secondary role. The Fed, however, strives to balance both.
The Current State of the US Economy
Due to the aggressive interest rate hikes implemented earlier, inflation has been steadily declining. The Fed aims for a 2% inflation rate, and if we were to extrapolate the current trend, achieving this target seems well within reach.
This positive outlook led to a surge in confidence among Fed officials towards the end of last year, with many hinting at upcoming rate cuts. Consequently, market expectations in the first quarter of this year reflected a 75% probability of a rate cut by March.
However, data from the first half of the year revealed a slower-than-expected decline in inflation, while unemployment rates remained relatively stable in the first quarter. This prompted the Fed to hesitate, delaying the anticipated rate cuts.
Finally, by July and August, inflation data showed a significant decline, coupled with a rise in unemployment. This development simplified the decision-making process for the Fed, making rate cuts a clear course of action.
A Timely Adjustment
Adding to this, a news release on August 21st provided further support for a rate cut. The US Bureau of Labor Statistics announced a revision of their previously released data on job growth in the previous year. While the initial report indicated a growth of 290,000 jobs, a correction revealed a significantly lower figure of 210,000, marking the largest data revision in 15 years.
Although this revision painted a somewhat negative picture of the US economy, it solidified the case for a rate cut by the Fed. The job market appeared to be cooling down more than anticipated.
With both conditions for a rate cut – declining inflation and rising unemployment – in place, the decision became straightforward.
The Pace of Rate Cuts: Why the Urgency?
The expectation of a swift rate cut cycle, with the Fed completing it within a year, stems from their historical approach of "slow and steady increases, quick and decisive cuts."
The reasoning behind this approach is rooted in the impact of interest rate adjustments on market behavior. Rate hikes, being restrictive in nature, are implemented gradually to allow the market to adapt and prepare. However, the unprecedented pace of rate hikes in 2022 was a necessary response to the rapid surge in inflation.
On the other hand, rate cuts, which typically lower borrowing costs and encourage spending, need to be swift and decisive. Prolonged and gradual rate cuts could create an expectation of continuously declining rates in the future, potentially discouraging immediate spending and investment. This could inadvertently hinder economic growth instead of stimulating it.
While a rapid approach is preferred, a sudden and significant cut of 200 basis points in one go could send the wrong signal to the market, creating panic and instability.
The Importance of Signaling
The intense scrutiny of the Fed's every move by market analysts, attempting to predict the timing and magnitude of rate adjustments, might seem excessive. However, it highlights the significance of these signals in deciphering the Fed's policy path.
The market seeks to gauge the future trajectory of rate cuts based on the size and speed of the initial move.
It's important to remember that these are simply market expectations and not guarantees. The actual implementation of rate cuts will depend on the evolving economic landscape, with factors like inflation, unemployment, and other variables playing a crucial role.
Factors Influencing the Fed's Decision
While inflation and unemployment remain the primary drivers of the Fed's decisions, other factors also come into play, even if not explicitly acknowledged.
The Stock Market
The Fed pays close attention to the stock market, perhaps more so than many other central banks. This is partly due to the close relationship between the US stock market and the real economy. Some speculate that the Fed may be influenced by Wall Street to some extent. Regardless, a significant decline in the US stock market could prompt the Fed to intervene and stimulate the economy.
The US Election Year
The upcoming US election adds another layer of complexity to the Fed's decision-making process. There's a prevailing belief that the delay in rate cuts this year stemmed from the Fed's desire to avoid any perception of favoring the incumbent Democratic Party. Early rate cuts could have been misconstrued as an attempt to boost the ruling party's popularity.
Furthermore, the outcome of the election adds to the uncertainty. A potential Trump victory could usher in significant policy changes, such as tax cuts or protectionist trade policies, creating unpredictable outcomes. This uncertainty might be another reason for the Fed's cautious approach to rate cuts, preserving its ammunition for future adjustments.
The Value of the Dollar
The Fed also considers the trajectory of the US dollar, or more broadly, the movements of other currencies and the policy decisions of other central banks. Significant appreciation or depreciation of the dollar could influence the Fed's policy choices.
However, the past three decades haven't witnessed any dramatic interventions based solely on currency fluctuations. One notable exception was in 1985, when the Fed lowered rates to counteract the dollar's strength.
Data Dependence
Throughout this process, Chair Powell has consistently emphasized the Fed's "data-dependent" approach, reiterating that their policy decisions are driven by economic data rather than external pressures.
The "Boring" Fed: A Sign of Stability?
Ideally, the Fed aims to function as a "boring" entity, as paradoxical as it may sound. This "boring" nature, characterized by predictable and data-driven policy decisions that align with market expectations, is a sign of stability and reduced uncertainty, which are highly valued in financial markets.
This approach stands in contrast to the Greenspan era, marked by unexpected policy shifts. Over time, with Bernanke and subsequently Yellen and Powell, the Fed has adopted a more systematic and predictable approach, recognizing the importance of managing market expectations.
This shift towards predictability is evident in the way the Fed communicates its intentions well in advance, signaling policy changes with ample time for the market to adjust. This approach fosters stability and mitigates the risk of sudden shocks.
The European Central Bank, under Christine Lagarde, seems to be emulating this approach, with Lagarde frequently emphasizing their data-driven decision-making process.
Market Reactions to Rate Cuts: A Historical Perspective
Let's now delve into how the market has historically reacted to Fed rate cuts. It's crucial to remember that these are just past trends and not guaranteed future outcomes.
The Theoretical Impact
Theoretically, here's how the market should react to a decrease in US dollar interest rates:
- US Stocks: Prices should rise due to lower borrowing costs for listed companies, higher valuations of future cash flows, and potential boosts in revenue from economic stimulus.
- US Bonds: Prices should increase due to the inverse relationship between bond yields and prices.
- Foreign Stocks: Prices could rise as lower US interest rates might make foreign assets more attractive, driving capital flow.
- US Dollar: Value should decrease as lower interest rates make holding the currency less appealing.
- Foreign Currencies: Value should appreciate relative to the US dollar.
- Gold Prices: Prices should increase as a weaker dollar and lower bond yields enhance the appeal of gold as a safe-haven asset.
- Oil Prices: Prices should increase due to both a weaker dollar and a potential increase in global demand fueled by US economic stimulus.
- US Housing Prices: Prices should rise as lower interest rates make mortgages more affordable.
- Chinese Yuan: Value should appreciate against the US dollar, similar to other foreign currencies.
Historical Reality vs. Theoretical Expectations
However, a look at the past six major rate cut cycles since 1980 reveals a different story.
- US Dollar: Contrary to expectations, the dollar appreciated in three out of the six cycles (1981, 2007-2008, and 2020). This deviation can be attributed to external factors like the oil crisis in 1981, the global financial crisis in 2007-2008, and the COVID-19 pandemic in 2020, all of which triggered a flight to safety, boosting the dollar's value.
- Global Stocks: The performance of global stock markets during these periods has been inconsistent. While some cycles saw significant gains (1981 and 1984), others witnessed substantial declines due to factors like the bursting of the Japanese asset bubble in 1990, the dot-com bubble in 2000, the global financial crisis in 2008, and the COVID-19 pandemic in 2020.
- Gold: As expected, gold prices generally rose during these periods, driven by both the weaker dollar and increased demand for safe-haven assets during crises.
- Oil: Contrary to theoretical expectations, oil prices mostly declined during these periods, primarily due to decreased demand during economic downturns.
The Importance of Context
These historical examples highlight that while theoretical models provide a framework, real-world outcomes are influenced by a complex interplay of factors, with crises and unforeseen events playing a significant role.
The observation that market reactions often deviate from theoretical expectations during rate cut cycles might lead one to believe that rate cuts cause recessions. However, this is a misinterpretation of causality.
The recessions observed during these periods were not a direct result of rate cuts but rather a consequence of underlying economic vulnerabilities. Rate cuts were often implemented as a response to these vulnerabilities, either too late or with insufficient force to prevent a downturn.
The question of whether the US can achieve a "soft landing" this time, avoiding a recession while transitioning to a normal interest rate and inflation environment, remains uncertain. While historical precedent suggests it's a rare occurrence, market analysts seem cautiously optimistic about the current situation.
A successful soft landing would likely benefit both the stock and bond markets, potentially leading to outcomes closer to those predicted by theoretical models. However, numerous risks and uncertainties remain, including the US election, geopolitical tensions, and the possibility of resurgent inflation. Navigating these complexities will require careful monitoring and adaptability.
The Long-Term Impact of Rate Cuts: Excess Liquidity
Despite the short-term volatility and unpredictable market reactions, one common thread runs through most rate cut cycles – excess liquidity.
When the Fed cuts rates, other central banks often follow suit, injecting a surge of liquidity, primarily in the form of US dollars, into the global financial system. This influx of capital seeks higher returns, flowing into various asset classes and regions, often inflating asset bubbles and creating conditions ripe for future crises.
Historical examples include:
- The Latin American debt crisis in the 1980s, fueled by capital inflows after the 1980 rate cuts.
- The Japanese asset bubble in the late 1980s, inflated by capital inflows after the 1985 rate cuts.
- The Asian financial crisis in the late 1990s, partly driven by capital inflows after the 1990 rate cuts.
- The US housing bubble in the mid-2000s, fueled by easy credit after the 2000 rate cuts.
- The bull market following the 2008 and 2020 rate cuts, driven by massive liquidity injections.
It's crucial to understand that these are merely correlations, not causal relationships. Attributing these crises solely to Fed rate cuts would be an oversimplification. Nonetheless, recognizing the potential for excess liquidity to contribute to financial instability is crucial.
Global Central Bank Responses
How are other central banks responding to the Fed's rate cuts?
The US dollar's dominance in the global financial system compels most central banks to align their monetary policies with the Fed's actions to some extent.
When the Fed raises rates, capital flows towards the US dollar, often forcing other central banks to raise rates as well to stem capital flight and stabilize their currencies. This interconnectedness limits the independence of other central banks, particularly those with open economies heavily reliant on the US dollar.
This time, however, many countries, including Switzerland, Canada, the Eurozone, and the UK, preemptively cut rates ahead of the Fed. This proactive approach stems from weaker economic conditions in these regions compared to the US. With inflation under control and economic data painting a less optimistic picture, these countries chose to front-load their rate cuts in anticipation of the Fed's move.
Exceptions to the Rule: Japan and Russia
Despite the global trend towards rate cuts, some countries are marching to a different tune.
Japan, for instance, is grappling with an economic cycle out of sync with the US and Europe. After years of aggressive stimulus measures, Japan is finally witnessing a resurgence in inflation. Consequently, the Bank of Japan is focused on raising rates to cool down the economy, putting it at odds with the global trend.
This divergence has put significant upward pressure on the Japanese yen. The carry trade, where investors borrow in low-yielding currencies like the yen to invest in higher-yielding assets, has unwound as the interest rate differential between the US and Japan narrows. This has caused the yen to appreciate rapidly against the dollar, potentially hindering Japan's export-oriented economy.
The Bank of Japan's concerns about the yen's appreciation might limit the pace of future rate hikes. If the yen strengthens excessively, the Bank of Japan might be forced to halt its rate hikes or intervene in the currency market to prevent further appreciation.
Another outlier is Russia, which is contending with the inflationary pressures of a prolonged war. Capital controls, military spending, government borrowing, and potential money printing have all contributed to a surge in inflation. Consequently, the Russian central bank has been forced to raise its key interest rate from 16% to 19% and might continue tightening monetary policy.
Conclusion: Navigating Uncertainty
Understanding the complexities of the global financial system, the interconnectedness of central bank policies, and the potential impact of the Fed's actions on the global economy is crucial for navigating today's uncertain times.
While predicting the future with certainty remains impossible, recognizing the historical patterns, potential risks, and influencing factors empowers us to make more informed decisions and navigate the complexities of the global financial landscape.