We will soon enough discuss the Fed’s unseemly super-sized rate cut of 50 basis points. Keep in mind that this is way out of normal ranges. Historically, reductions of this magnitude occurred only when the central bank or its pet charges, banks and big financial players, were in freakout mode. The last time the Fed made this big a rate slash was during the worst of the financial crisis, in October 2008.
But the fact that the US and other advanced economies have gotten themselves in the situation where they have shifted so much responsibility for economic management to democratically unaccountable central banks merits some comment.
It’s not hard, and not even all that wrong, to blame where we are on Milton Friedman. Yes, he was far from the only leading light of the libertarian campaign which has been a rousing success in making governments loath to govern. But Friedman was a tireless and very effective propagandist, which included a best-selling book, “Free to Choose” and a multi-part TV series of the same name.
The problem with where we have wound up in the US is that dirigisme is a dirty word, yet we have an extremely large number of interventions in the economy at the product/sector level via targeted government spending programs and tax breaks. The result is what I call industrial policy by default, as in the funds go not based on a top-down idea of what national priorities and macroeconomic policies should be, but the effectiveness of various special interests in getting goodies. Mind you, some of the latter is inevitable. But in the US, the degree of spending and price distortions that are the direct result of subsidies shows this system is doing affirmative harm. Overpriced housing, a bloated and not very effective military, a patient-gouging, underperforming health care sector, and wildly expensive, administrator-enriching higher education system are the most glaring examples.
Friedman, described by his son as a libertarian anarchist, also wanted central banks to play a limited role. His belief that money supply growth regulated economic activity, if it had been correct, would have limited central bank freedom of action. They would have been expected in all but highly abnormal times (think the Covid shock) to set a monetary growth rate and leave it be. But experiments by the Reagan and Thatcher governments with trying to manage via monetary targets found that monetary growth correlated with no economic variable, so the idea fell out of fashion.
While this is a deliberately oversimplified story, it does help explain why we got where we are now, with Administrations pretending they aren’t much responsible for overall economic management, and the Fed being expected to fill the gaps. So we have policy schizophrenia, with the Biden Administration running large fiscal deficits while the Fed keeps monetary policy very tight to try to compensate.
And do not kid yourself that monetary easing is a very good way to try to boost groaf. The effect of interest rates is asymmetrical: higher interest rates can and do constrain growth by making borrowing to fund expansion or mere upkeep more expensive. But most executive and business owners will not invest in new capacity just because money has gone on sale. They beef up operations in response to signs of more demand in their sector, or perhaps improvements in an adjacent line of business that they’d like to exploit. The big exception to this rule is operations where the cost of borrowing is one of their biggest expenses. That translates into financial institutions and leveraged speculators (which includes some real estate developers).
If you have any doubt, look at the decade following the financial crisis. The Obama Administration was criticized for not running a big enough deficit to counteract the economic shock. Instead the Fed and other central banks held interest rates in negative real interest rate terrain. And what resulted? A protracted period of widely decried secular stagnation.
So now to the unseemly 50 basis point cut. Mr. Market having lobbied so hard for it no doubt at least partly explains the comparatively limited commentary on why the Fed thought such a big reduction was warranted. Admittedly, the Bureau of Labor Statistic made a big downward revision to job growth in late August. But many analysts regarded this change as not all that worrisome. For instance, from CNBC:
- No recession has been declared.
- The 4-week moving average of jobless claims at 235,000 is unchanged from a year ago. The insured unemployment rate at 1.2% has been unchanged since March 2023. Both are a fraction of what they were during the 2009 recession.
- Reported GDP has been positive for eight straight quarters. It would have been positive for longer if not for a quirk in the data for two quarters in early 2022.
As a signal of deep weakness in the economy, this big revision is, for now, an outlier compared to the contemporaneous data.
Similarly, right before the Fed made its decision, the widely-considered-to-be-very-accurate Atlanta Fed GDP Now, said the economy was percolating along nicely. The 3Q estimate had just been revised down from 3.0% to a still nicely expansive 2.9%.
New Dealdemocrat argues that that plus other indicators show a recession is no where in sight (forgive me for omitting the charts; you can get the drift of the gist without them and check at the link if you want to verify):
There are some economic and financial indicators that aren’t classic leading or lagging indicators. Rather, they are “over-sensitive” in one direction or another. Two good examples are heavy truck sales and the unemployment rate: they are over-sensitive to the downside: they lead going in to recessions, but lag coming out.
The S&P 500 stock market index fits in this category as well. The classic aphorism is “the stock market has predicted 9 of the last 4 recessions.”
But the converse is not true. With the stellar exception of 1929, when stocks themselves were in a bubble, if the market makes a new high, it’s almost a sure bet that the economy is not in a recession….
Another way to look at that is to update my “quick and dirty” economic indicator of the YoY% change in stocks and the inverted YoY% change in initial jobless claims. Here’s what that looked like in the five years before the pandemic, showing that stock prices were lower YoY several times with no recession occurring (showing how they are over-sensitive to the downside).
Now on the flip side, there’s been a lot of anecdata about collapses in demand at certain retailers, from Dollar Stores to Wayfair. And although it does not come out cleanly in data, the US seems even more than ever to be a two-tier economy, with those on the bottom still very much squeezed by price increases. Even if prices are not going up much now, past prices are seldom being rolled back and wage growth is still far from making them whole.
In keeping, the Wall Street Journal pumped for a big rate cut right before the Fed made its move, in, Americans Are Desperate for Relief. The Rate Cut Is a Glimmer of Hope. Representative sections:
Just as it took time for higher rates to slow things down, it will take time for rate cuts to speed things up.
The cuts will make many household budgets stronger, on balance, and potentially begin to lift some of the bad economic vibes that have puzzled Washington and Wall Street. Across the world’s largest economy, those little differences are multiplied by millions of people who borrow money to finance big purchases, invest in companies or buy day-to-day necessities.
The article then turns to a heartwarming story of a couple that stretched to buy a home in very pricey Seattle with a mortgage at 6.99%. They are explicit that they bet on being able to refi and get their monthly costs down. Consider Investopedia on this topic:
One of the best and most common reasons to refinance is to lower your loan’s interest rate. Historically, the rule of thumb has been that refinancing is a good idea if you can reduce your interest rate by at least 2%. However, many lenders say 1% savings is enough of an incentive to refinance.
Why would lenders give that advice? Because they skim off a lot of the economic value of the lower financing costs in their fees!
Having said that, it is true that mortgage interest rates affect the economy is via refis. This was a not-well-acknowledged source of stimulus in the post crisis era. Many homeowners increased their disposable spending levels by refinancing at bargain-basement mortgage interest rates. But a 50 basis point reduction from a high level will produce bupkis on this front.
And to add insult to injury, the Fed move did not further lower mortgage rates, in fact they increased a smidge. From Morningstar:
Here’s a puzzle for market watchers: Hours after the Federal Reserve cut interest rates Wednesday for the first time since 2020, mortgage rates ticked up by 4 basis points.
Why? And are mortgage rates on an upward trend from here on out?
MarketWatch spoke to economists who said that the increase is a temporary one, likely due to how markets are assessing the central bank’s next move.
“This is a temporary blip. There’s no reason why they shouldn’t continue their decline for a while,” Robert Frick, a corporate economist at Navy Federal Credit Union, told MarketWatch.
“I fully expect that (the 30-year mortgage rate) will settle below 6% in the next month or two,” he said. “So my advice would be (for people to) try to not read too much into it, because the market is fickle.”
One argument for the Fed action is to help home buyers who in many cases find housing to be unaffordable. But as Wolf Richer pointed out in a post-rate cut piece: Demand for Existing Homes Wilts, Supply Spikes to Highest for any August since 2018, Prices Dip, Despite Mortgage Rates that Have Plunged for 10 Months. Wolf maintains that most markets are in the throes of a buyer’s strike because prices are still too high. Of course, the other way to look at this is wage growth has been too low.
We’ll now return to the Journal’s plea for cuts:
Now that rates are moving down, that alone could be enough to make more households and businesses feel all right about spending. The Fed’s projections released Wednesday suggested that the central bank will cut rates by another 1.5 percentage points by the end of next year.
In other words, the Confidence Fairy has returned. As we indicated, her magic didn’t work terribly well post crisis, with extreme rate reductions. So why should now be different? The Journal turns from housing to cars:
Even so, Fed cuts will gradually ease some of the pressure on prospective car buyers heading to dealerships such as Stehouwer Auto Sales in Grand Rapids, Mich. Three years ago, Vice President Kelly Herb said customers with top-tier credit scores could buy a year-old car with a loan that had an annual percentage rate as low as 2%. He estimated that the roughly 6% rates now common would translate to about $50 more a month under that scenario.
“When times are good, people don’t really ask about rates,” said Herb, whose customers struggle with more expensive child care and housing. “When times are like they are now, it’s one of the first things they ask.”
The used-car dealership now sells roughly 30 vehicles a month, the longtime salesman said, down from as many as 50 during the pandemic when rates were low and government stimulus was flowing.
Again, used cars skew more to the bottom half of the two-tier economy. Even so, as some readers have pointed out, in the long-ago days of their youth, it was possible to buy a new car outright on merely some months of savings on modest wage. The fact that living costs across the board have gone up so much over time that car financing is now pervasive is seldom questioned.
Reading into the tone, as opposed to the particulars, of the Journal story, one senses the authors are having to work a bit to demonstrate real economy, as opposed to financial market, impact.
So why the big cut? One could be cognitive capture, that Mr. Market had been nagging the Fed so long for its precious rate-reduction boost that some at the central bank had internalized that it was overdue despite inflation figures not giving them the justification they wanted. So the outsized reduction included some perceived catch-up.
A second possible reason is political. Trump has made clear Powell is out if he wins. This rate cut comes too late to give the economy any lift before the election. But the impact on stocks and bonds will cheer investors, some of whom are donors. So Powell may hope that this action will put him in good stead with a Harris Administration.
A variant of the notion politics played a part is that three Democratic senators, led by Elizabeth Warren, wrote the central bank calling for a 75 basis point cut. 75 historically has happened only in “shit hitting the wall” level crisis times, so if even the Senators has gotten what they wanted, it could well have backfired by signaling that the central bank was seeing multiple indicators of serious problems.
An alternate view is that the Fed really was panicked. One proponent is Tuomas Malinen:
Make no mistake. 50bps cut, is a panic cut. So, why did the Fed panic?
Most likely, there were four reasons:
- The Fed is racking up massive losses.
- Political pressure to not crash the markets before the Presidential elections on November 5 (last FOMC meeting before).
- The Federal Reserve is genuinely worried about the economy, but especially about debt levels.
- Banking sector fragility.
We’ll put aside #2 since we discussed it briefly above, and #1 since central banks don’t need positive equity. His arguments for points #3 and #4:
I concluded my last weeks piece by noting:
Banks seem somewhat optimistic and they have eased lending standards. There is not much room for leveraging among corporations and especially among households, though, which shows in the stagnation of borrowing. This indicates that the optimism among banks is likely to be a “false positive”. Their optimism can, for example, be based on the assumption that the Fed easing would create favorable conditions for an economic recovery. Due to the very high level of indebtedness of households and corporations, I consider this to be unlikely. This implies that we could see, possibly a drastic, turn into re-tightening of lending standards and softening of credit demand in the coming quarters….
U.S. banks continue to struggle under a gargantuan amount of unrealized losses. They arise mostly from the same source as with the Fed, i.e. from Treasuries losing value, en masse. We also noted in the August World Economic Outlook of GnS Economics that the outflow of core deposits seem to have re-started. Deposit outflow is a major risk for the banking sector, because it implies waning trust and, as banking is a business of trust, waning trust implies growing fragility in the banking sector. The Fed cannot stop the outflow of deposits, but it can try to diminish the unrealized losses by cutting interest rates, and hoping that Treasury yields follow. At the time of writing, this was not going well with, e.g. the yield of U.S. 10-year Treasury note shooting up. This is an (early) indication that the bond market now expects inflation to pick up.
Malinen oddly omits a big source of pain at many banks, which is lending to office space in major metro areas, particularly in so-called B and C space, as in older buildings in non-prime locations. These properties are causing serious problems not just for banks but their cities, since it’s pretty sure there will never again be enough demand to re-fill these buildings as office space, and they aren’t well suited to a fix that is being selectively implemented, that of converting them to residential space (before you pooh-pooh, that has happened to a considerable degree in the Wall Street area, but even though the buildings were not-so-hot, many had enough open or water views to make the conversions viable).
Arguing against Malinen is that we’ve seen a lot less overt distress, particularly since the Fed offered a bailout-of-sorts via special liquidity facilities. However, the Fed could easily be have been on the receiving end of intense private lobbying, with the banks making a combination of actual and exaggerated claims of being in a world of hurt.
The information here is so fragmentary and anecdote-driven that it probably makes more sense to see if there is further corroboration of any of these views. But if readers have any local intel, that can still help flesh out a better picture.
