Why no one should be celebrating the Fed’s super-sized rate cut
Having pushed shares to record levels, investors must now ask themselves what an emergency move from the Federal Reserve says about where global markets are heading.
Chanticleer AFR
Sep 19, 2024 – 7.59am
Yes, 105 out of 114 economists can be wrong. And this time, you can’t really blame them.
The vast, vast majority of economists surveyed by Bloomberg before the Federal Reserve’s interest rates decision on Wednesday night (Thursday morning AEST) expected a 0.25 percentage point cut. They are now scrambling to explain why Fed chairman Jerome Powell delivered a 0.5 percentage point cut, which brings official US rates to 4.75 per cent and 5 per cent.
Cuts of this size are rare, and have traditionally been used in only emergencies. The last two times the Fed cut by 50 basis points were in January 2001, as the dotcom bubble was bursting, and in September 2007, when the GFC was just gathering pace.
So how on earth do we get a 50 basis point cut when inflation is falling but still a little sticky (the co-called supercore inflation measure the Fed looks at, which excludes all goods prices, food and energy prices, and housing costs, is stuck at 4.5 per cent) and US GDP growth remains robust at 3 per cent? Does Powell know something that we don’t about the state of the economy? Has the Fed suddenly decided it’s behind the curve?
The Fed chairman used his entire press conference to assure the world that this is the equivalent of an economic pre-emptive strike – the US labour market is softening, and this is the cut designed to ensure it doesn’t soften further.
Future rate cuts aren’t likely to be as big as this one, Powell suggested, and the rate cut projections for the rest of this year and next, as presented in the latest “dot plot” released on Wednesday night, are much more modest than money markets are expecting.
“We don’t think we’re behind,” Powell declared. “You can take this as a sign of our commitment not to get behind.”
And as for that R word, don’t even mention it – though, whoops, Powell accidentally did.
“I don’t see anything in the economy right now that suggests that the likelihood of a recession, sorry, of a downturn is elevated,” he told the press conference.
“I don’t see that. You see growth at a solid rate. You see inflation coming down. You see a labour market that’s still at very solid levels.”
So let’s sum this up.
The economy is still pretty strong. But an emergency-sized rate cut was still warranted. Now we can go back to regular 0.25 percentage point cuts. Because the economy is still pretty strong, remember.
Clear as mud?
Equity markets were justifiably confused. The S&P 500 jumped after the Fed decision, to be 1 per cent higher on the day midway through the New York afternoon, but then lost all momentum to finish the day marginally in the red. History sends a warning
To be fair, Wall Street had run pretty hard into this announcement, as a series of carefully calibrated leaks to the media (particularly The Wall Street Journal’s chief economics correspondent, Nick Timiraos, whose incredible contacts inside the central bank have earned him the moniker “Nicki Leaks” made it clear a 0.5 percentage point cut was very much in play. The market moved higher for seven straight sessions before Wednesday night, and was up almost 5 per cent since September 6.
So while the Fed has given equity investors exactly what they were looking for, they still have plenty of reasons to be cautious.
The first, of course, is history.
Of the past 12 rate cutting cycles, eight have ended in a hard landing, and four in a soft landing – and all of those hard landings were preceded by the inversion of the yield curve, as we’ve just experienced.
Further, as Nick Ferres, chief investment officer of macro fund Vantage Point, has been pointing out for months, in the 200 days following the first cut, equities typically decline by 23 per cent on average, because the start of the rate cycle signals the beginning of a deterioration in growth and profits.
By couching his super-sized rate cut with reassurances on the state of the economy, Powell is trying to tell the market that it’s all under control, that the economy won’t deteriorate in a way that will result in a hard landing.
But history says investors should be nervous of Powell’s suggestion this is a mere “recalibration” of monetary policy settings, a word he used no less than nine times in his press conference. The data-dependent Fed is tweaking the dials on what appears to be pretty flaky data – as evidenced by the massive downwards revisions to the official jobs data we’ve seen in recent months – and central banks are not known for getting minute adjustments just right.
It’s silly to try to read the mood of the market at the best of times. But perhaps the limp end to trade on Wall Street on Wednesday night was, as Ferres suggests, investors looking past Powell’s reassurances and at least starting to think through the risks to growth and profits from a weakening economy.
And given how stretched sharemarket valuations are, how crowded positioning is, and how poor risk compensation is, some circumspection is probably warranted. Another inflation scare ahead?
The second, and probably lesser, reason for investor caution is that Powell may be right on the resilience of the economy, and the big rate cut sparks a new wave of inflationary pressures.
Peter Berezin, chief global strategist at the influential BCA Research, is one of those who got his rate cut call wrong and is sceptical of Powell’s soft landing message.
“The Fed also cut rates by 100 bps in the months leading up to the 2001 and 2008-09 recessions. It was simply too little, too late back then. With unemployment now trending higher, this time may not be any different.”
But Berezin also says the size of this cut means he now also needs to increase the probability of a second wave of inflation, which could actually be uglier. While the US would avoid a recession in the near term, we could see “an even deeper recession down the road, as the Fed is eventually forced to slam on the brakes”, he says.
“The whole thing reminds me of Milton Friedman’s ‘Fool in the Shower’ metaphor of someone trying to find the right temperature for the water but being stymied by the long lag between when the dial is turned and when the water temperature adjusts.
“Monetary policy works with long and variable lags. The Fed could get lucky and turn the dial so that the US economy neither overheats nor freezes over. But with the S&P 500 at record highs, that does not seem like a good bet to me.”
Amid Powell’s mixed messages on Wednesday night, there was one point he was very clear on: we won’t be returning to the days of ultra-low and even negative interest rates any time soon.
This backs up the point made forcefully by Wall Street titan Howard Marks this month: investors need to worry less about the details of the next rate move, and instead focus on the direction of travel. That suggests the 40-year decline in interest rates we enjoyed from 1980 to 2020 is done, and rates will settle much higher.
Bank of America calls it the structural shift from a 2 per cent world – the average rate between 2000 and 2020 – and a 5 per cent world. The combination of fading globalisation, ageing populations, populist politics and huge budget deficits and surging energy demand (both via the energy transition and artificial intelligence) means inflationary pressures will remain higher for longer.
made it clear a 0.5 percentage point cut was very much in play. The market moved higher for seven straight sessions before Wednesday night, and was up almost 5 per cent since September 6.
