How Did We Get Here?
Talks of a rate cut may seem unsettling because the economy is doing great, by a lot of measures. Job growth in June averaged over 200,000, Gross Domestic Product (GDP) is performing around potential, and the stock market keeps hitting record highs. Things aren’t completely rosy though. For example, the current inflation rate of 1.5% is, and consistently remains, below the 2.0% target. Low inflation alone wouldn’t be enough to warrant a rate cut but Fed officials are looking at the broader picture:
- The trade wars appear to be weighing on manufacturing and business confidence
- Corporate spending on capital expenditures is slowing as the sugar high following the tax reform wears off
- The milestone of the longest economic expansion on record in July has consumers on high-alert
- Global data suggests a slowdown in major economies across the world, including China and Germany
Given this information, the Fed has two choices: they can cut rates today as an insurance policy or wait until the data captures a clear and broad-based slowdown.
Boost Or Bust
Rate cuts are used to reignite an economy by encouraging lending and supporting consumer and business spending. Historically, enacting expansionary monetary policy in the US has produced mixed results. In 1995 and 1998, small rate cuts did prolong the economic expansion. However, for 2001 and 2007, a recession was soon-to-follow. A likely cut later this month does not necessarily mean the start of an easing cycle and will give the Fed time to see if it boosts economic activity. Below are three key impacts from a rate cut:
- Reverse a warning sign. A ‘reliable’ predictor of past recessions, the spread between the 10-year bond vs. 3-month Treasury bill, inverted in May. The 3-month Treasury bill yield is closely tied to the federal funds rate and market forces drive the 10-year bond. A lower federal funds rate could push the spread back to positive territory.
- Mortgage rates could rise. Mortgage rates are closely tied to the 10-year Treasury yield and the former has followed the latter down throughout 2019. As a result, the bond market essentially gave the homebuilding industry four quarter-point rate cuts. Counterintuitively, if the Fed lowers short-term rates, the 10-year yield could rise as investors are encouraged by future economic growth.
- Positive bump from equities. The stock market is not the economy but the two can influence each other. Stock investors are anticipating a rate cut and history tells us they view the move favorably. If the stock market keeps breaking records, the economy could hit its stride in a virtuous cycle for confidence.
The Fed is expected to follow through with the rate cut at the end of this month barring any unexpected change to economic data. There are potential upsides that can keep this economic expansion marching forward but also fundamental concerns that should not be ignored. A serious and often forgotten question is — why can’t the economy operate with rates at historically low levels? Rates are low enough to keep credit flowing and the fact that today’s economy needs a boost is worrisome.