The Fed’s Upcoming Blunder (4 min read)
What a difference seven months makes. At the end of November 2018, financial markets priced the Fed funds rate (then 2.2%) to end 2020 at about 2.7%. Now, however, the market expects the rate to end 2020 at about 1.5%. The pricing of three cuts in the second half of 2019 and a further one or two in 2020 is aggressive, and yet, as I’ll explore below, the easings will probably fail provide substantial support to the economy, especially so late in the cycle. Instead, I predict that it will fuel financial excess, reduce policy options during a downturn, and ultimately question the credibility of the Fed.
What Good Will Easing Do?
Well, not much. A marginally lower cost of capital for businesses will struggle to offset the drag from the threat of disruption to global goods and services trade, resulting from both trade and technology tensions between the US and China in particular. One transmission mechanism is the exchange rate, although this effect is always modest for the (relatively closed) US economy, and dollar weakness has been diminished by the shift in easing expectations abroad. A more promising external development is the boost provided to EM growth by easier US financial conditions, helping unwind some of the damage done in 2018.
Interest rate reductions always work best through housing and credit-sensitive components of consumer spending such as auto sales (Chart 1). The reductions are most effective, however, only when the financial system is strong enough and therefore willing and able to pass on more attractive borrowing rates to households. This seems to be true today and interest-sensitive sectors have begun to respond to lower market rates that the Fed is expected to validate in the coming months. In my view, the H2 easing is likely to keep US growth in the 2-2.5% range through the early months of 2020.
The 1998 Parallel
The best analogy for this easing is the Fed late cycle adjustment of 1998, Q3-4, made in response to external weakness – the Asian and Russian crises (Chart 2). There were far more signs of domestic and global financial stress then than today, but the pace of domestic investment (and trend GDP growth) was also far higher than now. The growth scare that triggered 75bp in rate cuts was not evident in the GDP data, which sailed along at a steady 4.75%oya clip through 1997, 1998, and 1999.
Chart 1: US Interest-Sensitive Sectors
Source: Suttle Economics
Chart 2: The US Rebound in 1999
Source: Suttle Economics
The Q3-4 1998 easing began to be reversed in July 1999, largely in response to perceptions of financial overheating as the stock market boomed. The Fed did not have an explicit inflation target then, but the core PCE deflator was well below 2% (and its current level) throughout the 1990s late cycle episode (Chart 3). This was not then viewed as a major policy problem, but more a reflection of an additional economic benefit offered by the technology boom.
Chart 3: Core PCE Deflator Through Expansions
Source: Suttle Economics
Unlike the 1998 easing phase, however, it seems unlikely that the Fed might begin to reverse its 2019 easing in mid-2020, given the approach of what is almost certain to be a very contentious election in November. Yet it is worth remembering that the Fed tightened by 175bp between July 1999 and June 2000, with the last move of 50bp coming less than 5 months before the election. Given political pressures and constraints, it now seems more likely that tightening will come in 2021 once financial excesses (and overheating) have become more severe.
The Policy Mistake
In my view, the global easing now underway is a policy mistake for three reasons:
- Most importantly, it will promote further financial excess. This is a particular problem because financial excess, rather than an inflation overshoot (e.g. 1999-2000 and 2006-7), is already causing the overheating in the modern economy.
- Easing to stimulate growth when growth is only moderately low uses up scarce manoeuvring room for when it is truly needed. When the economy next turns down, this will require the use of other policy supports such as fiscal easing that are inherently harder to activate.
- Whether policymakers (especially the Fed) are conscious of it or not, they are generally sanctioning bad policy. This signals to rational politicians that central banks are up for grabs—a highly attractive source of power and support.
So What’s the Takeaway?
I’d expect 50bp of Fed easing during 2019H2, which is aggressive, but less than market pricing. The easing will bolster interest-sensitive consumer sectors, but won’t help capex much. In the past, such easings in the late stages of an expansion are reversed quickly, but in the current situation politics will probably delay the reversal to 2021. In the end, the easings will be viewed as an error, and we’d do well to react to them as such.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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