The Dark Side of the Rate Cut

Market expectations should not help drive monetary policy.

The U.S. stock market has been rallying in anticipation of two rate cuts by the U.S. Federal Reserve, the first of which we saw on July 31st. Yet, we wonder whether these rate cuts are for the right reason. The wrong reason could send the U.S. economy down the wrong path.

It May Have Been the Right Move, but for the Wrong Reason

The Fed cut its key lending rate at its July meeting for at least one of three possible reasons:

The first is political. While the president has made clear his preference for a dovish monetary policy, I don’t think the rate cut was the result of any political influence.

The second reason is economic concerns. This is the Fed’s official reason. In its post-meeting statement, the Fed cited “implications of global developments for the economic outlook as well as muted inflation pressures.” In fact, earlier this week, the  Wall Street Journal  reported that the previous Fed chair, Janet Yellen, said she shared these concerns and said a rate cut was justified. Of course, economic data is the right way to justify a rate cut, but I believe that the Fed is letting economic data share the spotlight with investor expectations.

That leads us to the third possible reason, financial market influence. The Fed has become very sensitive to the fact that financial market instability can impact U.S. economic health. Given heavy reliance on debt financing in the U.S., instability on Wall Street has the potential to drive Main Street into a recession. I believe the Fed is factoring the market’s rate expectations into its policy decisions to help keep the markets stable. To be sure, the Fed’s July (and possibly September) rate cut should help its dual mandate of maximizing employment and ensuring price stability. But, all of this may only help prevent a recession in the  short term . By also bowing to the market’s rate expectations, the Fed could end up driving asset price exuberance and significant market instability in the longer term that could, in turn, help trigger a recession.

Seeking to Engineer Market Stability Could Backfire

It should be no surprise that the Fed doesn’t want to be at the helm of another asset price crumble that helps lead to an economic recession. Based on comments in 2018 from Federal Reserve officials, the central bank believes market instability helped drive the two past U.S. recessions.

The markets have rallied in anticipation that a rate cut in July, as well as one in September, will be enough to head off a recession, making them “insurance cuts.” If the rally continues at this rate, I worry the Fed will be forced to deflate the market (given their sensitivity to inflated asset prices) through a form of monetary tightening or the market’s exuberance could eventually bust on its own. These scenarios could help drive a recession that the Fed seeks to avoid.

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