What's the REAL reason for rate cuts?
EDITOR'S NOTE
As you all know by now, I don't think the Fed can credibly cut rates tomorrow and say it's because the economy needs it. The great tariff scare of 2019 has so far mostly been just that...a scare, with some collateral damage to manufacturing.
Let's review: GDP grew 3.1% in the first quarter, 2.1% in the second quarter, and the data for the month of June has been surprisingly solid. We added 224,000 jobs last month, retail sales were strong, durable goods were strong, jobless claims remain historically low, and even factory output had its best gain of the year.
So if the Fed cuts rates tomorrow, it's not because the U.S. economy is dangerously weakening. What, then, is the real reason? Is it because... (A) Inflation is too low (B) Global growth is dangerously weak (C) The dollar is too strong (D) The yield curve is inverted (E) Trump wants it
My guess is (D), but let's quickly run through this.
Inflation is too low? Not new. It's been "too low" for a long time. As economist Bob Brusca points out, inflation "is and has been below 2% since 1996 on average with few exceptions." It's been running roughly 1.5% for the past seven years, using the Fed's PCE gauge.
And inflation is not suddenly, precipitously heading lower right now. As J.P. Morgan notes, the core PCE data out this morning--even with a 1.6% year-on-year reading for June--puts the three-month run-rate at 2.6% annualized. Goldman expects core PCE "will reach 2%+" by the fourth quarter.
What about global growth? Germany looks awful, China maybe less bad lately, but a global slowdown rarely poses a true threat to the U.S. economy. A drag, sure. The trade and tariff uncertainties make it all the murkier right now. But when the Fed cut in 1998, there was a massive financial panic kicked off by a wave of Asian debt defaults. We see nothing like that playing out now.
What about the dollar? Well, you tell me where it goes if the Fed cuts. Lower--or higher, on renewed U.S. growth expectations? And vice versa. Currency markets are notoriously difficult to predict. Don't we need to cut because "everybody else is"? Not if their cuts make their economies--and currencies--stronger as a result, right?
As for the pressure from President Trump, it's certainly there--but as likely, I think, to make the Fed not want to cut in order to appear strong and independent as likely to bend under his pressure.
So that brings us back to the inverted yield curve. I think the Fed simply realized they hiked one or two times too many last year--remember, this was as they were also shrinking the balance sheet while claiming that had no monetary policy impact. Cutting rates once or twice now un-inverts the curve, essentially correcting the "mistake," and everybody's happy.
Or are they? Sure, monetary policy acts with "long and variable lags," but the hikes don't appear to have slowed the U.S. that much. Rates have already reset way lower (the 10-year yield has dropped from almost 3.25% last autumn to roughly 2% today), mitigating the impact.
In fact, bonds look so frothy and one-way these days--25% of all sovereign and corporate bonds outstanding globally trade at negative yields, per Deutsche Bank!--the prudent thing may be for the Fed to lean against that, not fuel it further.
Guggenheim's Scott Minerd says the Fed should hike rates right now, not cut them. "The simplest way to avoid recession would be a rapid increase in the supply of labor," he notes--something we could fix with better immigration policy, not monetary policy.
People don't want to hear this, of course, because having the central bank "fix everything," a la Europe, is so much easier. But here's where that path leads: rate cuts to zero, then more bond buying, then equity purchases by the central bank, as is already playing out in Japan, and then what?
No joke, here are some actual steps being suggested by J.P. Morgan's Hiroshi Ugai for the Bank of Japan now: "Abolishing paper currency, taxing currency," or depreciating it through other bank tools. Wow. So we can either fix our immigration policy or end up having to tax people's cash. You can imagine how well that would play out in America.
I would love to see the Fed come out tomorrow and say, you know what? The "clouds gathered, but the storm never arrived," to quote Coke's CEO, and so we're not cutting after all, and the economy will be fine if Congress takes the ball because it's really not our ball to take here. Can you even imagine the market response?
I'll keep dreaming, and I'll see you tomorrow for decision day!
Kelly
P.S. I promise tomorrow's note will be short and sweet! Or short, at least ;-)
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