The Risk of Lowering Rates Too Soon

As I have written on this blog and discussed on my podcast, the Federal Reserve (Fed) runs the risk of waiting too long to initiate rate cuts. Keeping rates sustainably high for too long has historically triggered recessions. However, there is a real risk of being too early and failing to beat inflation. The Fed is walking a tightrope.

While my instinct remains that the Fed should start lowering rates, my position was challenged by a thoughtful podcast interview I recorded today (Aug. 27) with Georgetown professor and American Enterprise Institute economist, Michael Strain. The interview will be out in the next couple of weeks, but you can read his position in a recent article, “The Economy Is Not Rapidly Deteriorating.”

Strain rightfully points out that the economy is not in recession. In fact, the economy remains strong despite the Fed’s aggressive monetary measures. He makes 6 salient points about the state of the economy: “1) Labor demand remains strong. 2) Layoffs have not increased, though hiring is trending down. 3) Income growth is solid. 4) Consumers are still spending. 5) Economic growth is projected to finish the year strong. For example, Goldman Sachs’s Q3 GDP tracking estimate is for 2.6 percent growth at an annual rate. 6) There has been no obvious shock to the economy that could abruptly change the outlook.”

Regarding the recent uptick in unemployment he states, “Rule No. 1 of analyzing economic conditions: Do not over-interpret one item of data.” Thank you! I made the same observation on my podcast two weeks ago. Furthermore, he rightfully points out that the uptick is due to new entrants into the labor force via immigration and other factors. Additional job seekers is a very different story than business layoffs.

With the current macroeconomic backdrop of a resilient labor force and persistent inflation above the Fed’s 2% benchmark, he concludes that “the data very well could imply that the Fed should not cut at all in September.”

Strain’s position is a departure from the mainstream financial media’s narrative that we must cut rates now. However, his points warrant careful consideration as the risks of elevated inflation is no small problem.

My conversation with Strain highlights a concern that has been nagging me for weeks: What If the Fed prematurely lowers rates and then is forced to reinitiate rate hikes? If that occurs, the markets are in for a ride. This could precipitate a market selloff.

I also had an interview on my podcast (yet to be released) with world renowned banking expert, Charles Calomiris, and he believes that interest rates will be higher in the long-run.

However, the risks of waiting too long to lower rates are also significant. There’s a lag effect to the impacts of monetary and fiscal policy on an economy. When the Fed injected $5 trillion of liquidity into the economy in 2020 and when both the Trump and Biden administrations added another $4 trillion plus of fiscal stimulus in 2020 and 2021 – inflation didn’t surge until 2022. U.S. households didn’t start spending the excess cash in the early days of COVID. Initially, they padded their bank accounts, but the spigots eventually opened.

Likewise, the impact of rate hikes takes time to unfold. While some borrowers experienced the immediate impact of rate hikes such as corporations with floating rate debt or households with credit card debt, many other borrowers with fixed-rate loans such or mortgages are still enjoying ultra-low rates. Overtime, however, people move, corporations have to reissue debt, auto borrowers have to get new cars, and thus the cost of borrowing increases over time. As this slowly ripples through the economy, heightened borrowing costs threatens to slow the economy. If this runs too hot for too long, a recession will occur.

In many ways the Fed is flying without instruments. If the leading indicators of recession occur before the Fed initiates cuts, the damage will be done, and the economy will likely falter. The Fed is notorious for being late to the party.

If we are intellectually honest, the Fed is in a quandary. Regardless of what they do, risks occur in either scenario. As is the curse of central planning, the Fed lacks sovereign knowledge. Narayana Kocherlakota, a former president of the Minneapolis Fed once said: “One of the analogies people give is you're driving a car, but you only get to look in the rearview mirror.” We assume they have special knowledge and a supernatural capacity to keep the plates of the economy spinning, but that ain’t so.

We also have to remember that the Fed is influenced by a variety of incentives — many of them political. The assumption — and I hear this often — that they are an independent agency is deeply misguided. Banking —particularly central banking — has always been a political bargain. You will hear more about this in my upcoming podcast episode with Charles Calomiris. Furthermore, don’t forget that the President of the United States appoints the Federal Reserve Chair. Presidents have always placed outsized pressure on the Fed. The Fed’s dual mandate is not the only game in town.

The Fed’s stated historical dual mandate has been to promote maximum employment and stable prices, but these mandates have ballooned particularly since the Financial Crisis of 2008/09. Some are explicit and some are implicit. One explicit policy aim of the Fed is to facilitate lending programs to distressed banks — i.e. bailouts. For instance, the Dodd Frank Financial Reform Act determined for the Fed those banks that are considered “systemically important.” In other words, Congress has rubber-stamped which banks are “too big too fail.” As a byproduct of congressional and regulatory pressure, the Fed is even in the business now of promoting environmental policies. That is just a few of them. The Fed and the federal government have unhealthy co-dependency.

There are also implicit policy aims, such as promoting equity markets. I doubt anyone at the Fed would indicate overt concern for the equity markets, but it must influence their thinking. Lower interest rate environments have historically bolstered equity markets. If the equity markets deteriorate, the Fed is often implicated and the public, particularly lawmakers in Congress, are known to turn against them. Furthermore, No one running for reelection of high office wants the backdrop of a bear market. It is an election year after all.

Considering the Fed is at a crossroads of having two imperfect choices of lowering rates or holding them steady, the political incentives may be tipping the scales towards lower rates. But political motives aside, my gut still tells me it is prudent to lower rates soon, albeit gradually.

So what does all this mean? There is an old saying, “Don’t fight the Fed.” Regardless of whether the Fed is caving under political pressure or if they are seeking to get back to their dual mandate, they have clearly indicated that rates are coming down soon. This week at their annual conference in Jackson Hole, Wyoming, the Federal Reserve broadcast their intentions to start lowing rates in September. As an investor, that is good news for the equity and bond markets in the short-term.

This comes with caveats. Considering how uncertain the impacts of near-term monetary policy are, investors should proceed with caution. While I am optimistic and while I generally agree with the direction of the Fed, I am not spiking the ball just yet. If inflation remains elevated in the face of rate cuts – prepare for a reversal. Based on his public comments, the Federal Reserve Chairman, Jerome Powell, has a hawkish bent. Rates coming down and staying down is not a guarantee. Again, Michel Strain’s points are valid, and he may be right in the end. However, if the Fed lowers rates and inflation continues to move toward the 2% target, we are likely off to the races.

At this point we maintain a positive outlook for the next 12 months and encourage investors to stay focused on their long-term goals, but we are watching the Fed closely. The economy has strength, and we foresee sustained GDP growth. Nevertheless, if the Fed makes a mistake with their policy aims and inflation remains elevated, we are prepared to pivot.

Disclosures:

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Drew Benson and not necessarily those of Raymond James.

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Raymond James is not affiliated with and does not endorse the opinions or services of Michael Strain or Charles Calomiris.