Fed October Meeting Goes Exactly as Expected

Federal Reserve

Just about everyone was expecting a third quarter point cut in the Fed funds rate during Wednesday’s announcement, but we also got some reassurance of this as well.

The Federal Reserve has been known to overreact at times sometimes on the side of being cautious about not wanting to do too much to stimulate the economy, or more commonly, to do more than it should to water it down by tightening.

Some might think that three rate cuts in a row might be overdoing it a bit, especially given that it wasn’t that long ago that the Fed was telling us that everything was fine and no further stimulus was required. Three cuts in a row certainly is in sharp contrast to that, but as it turned out, these cuts were needed more to reverse the overambitious rate hiking and monetary tightening that we got over the last few years.

After the Great Recession hit, the Fed threw everything at the problem, reducing the Fed funds rate to 0.00%- 0.25%, which is their version of zero interest rates. It would take quite an event indeed for the Fed to reduce either of these numbers below zero, and it didn’t get much worse than in 2008, where immediate action was needed to prevent the economy from simply grinding to a halt and then collapsing.

It wasn’t even enough to lower the rate to zero and to run up the balance sheet of the Fed by buying massive amounts of bonds to inject capital in the economy, as the U.S. government also handed out $750 billion in relief to financial institutions, and it took everything to right the ship.

Things did pick up nicely, but not overly so, and after 7 straight years of the Fed rate at zero, they started to raise rates. From 2015 to 2018, the rate was raised by 2.5%, which is the equivalent of 10 quarter-point hikes.

Inflation is the key measure that the Fed looks at and worries about, and with the exception of 2011, where it rose to 3%, it has been kept well under control. 2011 was too early in the recovery for the Fed to consider tightening, so they left it alone and things cooled down.

Interestingly enough, 2014 and 2015 both had us below 1% for inflation, and this was the backdrop for the Fed starting its tightening by raising rates. The next year, we saw growth dip to 1.6%, but this did not slow down the new hawkish view as they kept raising rates nonetheless.

The Fed looks beyond the present though, and saw growth materializing, and we got past the little slowdown in 2016 to get GDP back above 2%. Things started to heat up more in the first half of 2018, so they added a whole point that year, and this were the ones that were clearly excessive. This cooled the economy but cooled it too much, and that’s when the talk of a potential recession started to really pick up.

We waited until the summer of 2019 to address this, although it wasn’t that this excessive tightening was having all that big of an effect, but this did take us away from the inflation goal of 2%. It’s expected that inflation will come in around 1.5% this year, including the effects of this new expansionary strategy, and while the Fed isn’t concerned that this loosening will be too much, they now do not see any more required for a while at least.

The Fed Makes it Clear That They Will Now Stand Pat

The market has the probability of another increase by the summer of 2020 at about 50%, and that might even be overestimating it given what the projections are for 2020 and 2021, with inflation expected to rise to the ideal of 2%, with growth pegged at a 1.9% average for the two years. That’s the way that they would draw it up if they could just directly determine these numbers, strategically located between the regions of too much and not enough.

In contrast to the prior two rate cuts, the Fed has made it clear that this will do the trick and keep things humming nicely. We probably could have gotten by just fine without these cuts, but when you are underperforming a little, it’s hard to question the wisdom of being proactive in looking to bring things up a bit to where you really want them instead of what is just acceptable.

The Fed also reminded us how fabulous the employment numbers are these days, and employment can be said to be the cornerstone of the economy as far as avoiding the real negative stuff. It is when too many people lose their jobs that the pain of a slowdown really gets noticed and felt overall.

Worsening employment numbers portray a contraction very unequivocally, whereas a growth rate of 2.5% versus 1.5% are both positive. Growth going negative does hurt, but negative growth happens when we get an actual economic contraction, which takes the job market with it.

The most important numbers here are actually the employment numbers, but inflation matters a lot too, and you want some inflation but not too much, along with the employment numbers being solid. High employment and high inflation need addressing, but high employment and low inflation is the ideal.

Even the stock market saw this all as a positive, where in other cases we saw selloffs, and the one in the first part of August lasted a whole two weeks. The perception was that the Fed didn’t seem committed enough for their liking to more cuts, but this time it was clear there won’t be any more, but the appetite of the market has now been satisfied it seems.

Not Worrying About Going Back Up is the Big Win for the Market

Fed Chairman Jay Powell actually made it very clear that the Fed would not raise rates again unless we saw a significant rise in inflation, and this statement might be more valuable to the market than the cut itself. We saw what happened when they took rate hikes off the table for now in last December’s meeting, so while the stock market likes rate cuts, it hates rate hikes even more. Not having to really worry about this very much is a big deal indeed.

While higher inflation is not something we should want, there is a darker side to doing too much easing, and this risk kicks in when you have to put the rates back up. The market is justified in hating rate hikes as much as they do, as this goes beyond their effect in slowing the economy, as it directly raises the rates and risk of all the debt that easing causes.

The rates drop, we borrow more, the rates go back up, and we’ve borrowed too much relative to the now higher cost of borrowing. This not only impacts business results, but it also can raise default rates a lot, by making it more difficult to service the debt that you took on when the going was good.

The Fed jacked up their funds rate from 1% to 5.5% between 2003 and 2006, which significantly reduced the ability to service debt, especially with those who had mortgages coming due that were at great risk of these rate hikes. People point fingers at the banks for what happened, and rightly so, but the Fed also has blood on their hands here and quite a bit of it in fact as they dealt the hand that almost brought down the house with too high rates.

There is still a risk that we may forget the lessons of 2008, as the Fed remains obsessed with inflation and needs to properly account for how their actions will impact default rates. Keeping inflation down is nice, doing it by way of causing a recession is not.

As long as inflation remains in check, and it is well in check in spite of these three recent rate cuts, all will remain well, but ir and when we start seeing it rise too much, this is where much more care and deliberation will need to be exercised by the Fed as to not cause another debt crisis, even though the next one will very likely be nothing as bad as in 2008.

Meanwhile, the stock market is happy, and if progress can continue to be made on the other big issue that they have, the trade war, we could be in for a very nice ride further up the ladder.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

Contact Andrew: andrew@marketreview.com

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