Hold That Cut: Should the Fed Have Kept Interest Rates Steady?

Holden Caulfield, the angsty protagonist of JD Salinger’s semi-notorious novel, The Catcher in the Rye, once said that

“Certain things, they should stay the way they are. You ought to be able to stick them in one of those big glass cases and just leave them alone.”

Is Holden’s introspective utterance applicable to interest rates?

On Wednesday, the Federal Reserve Open Market Committee announced a further 25 basis point cut in federal interest rates, lowering the target to 1.75%-2.00%, following the cut in the July which was the first since the financial crisis. This was, however, not a unanimous decision among all members. Three members dissented from the decision to lower rates; Kansas City Fed President Esther George and Boston Fed President Eric Rosengren preferred to hold rates steady, while St. Louis Fed President Jim Bullard wanted a deeper cut.

Of the Fed’s 17 top officials, including seven who don’t have a vote this year, nearly a third didn’t see a need for Wednesday’s cut, according to a chart of officials’ best projections of the appropriate path for rates. But seven saw room for still another rate cut this year.

The Fed claims to be highly data dependent, and while available data currently paints a complex picture of the economy, underlying fundamentals remain strong. Fed officials nudged up their forecast of economic growth this year, projecting GDP will increase by 2.2%, up from a 2.1% estimate in June. Over the next couple of years, the Fed expects growth to drop below 2%, but officials stayed well away from forecasting a recession. Unemployment continues at a 50-year low level of 3.7% and Manufacturing Index data released this week from the Philadelphia Federal Reserve remained above 0, at 12, indicating improving conditions. The Empire State Business Conditions Index also remained above 0, signalling expansion.

With the economy maintaining resilience even in the wake of a highly unpredictable Trade War and waning global growth, and the S&P 500 near all-time highs, it begs the question, is the tail wagging the dog as the Fed seeks to pacify investors who price in rate cuts? Monetary policy should be aiming to be a safety net for the economy rather than a stimulant trying to preserve as much momentum in the stock market as possible.

The economy is very clearly not in the throes of a recession where the Fed must use every piece of artillery in its arsenal to win the battle against a financial crisis. The 25 basis point cut is giving the economy an aspirin before it gets a headache. But there is no panacea for an inevitable recession following a 10 year expansionary period.

The rate cut itself sends a confusing message; one that the Federal Reserve is attempting to sustain prosperity through artificial means. Such stimulation may be necessary when the fundamental economic data is flashing red, however, such is not the case yet.

The New York Federal Reserve Probability Index, however, is at 37.93%. In the past, every time since 1960 that this index has breached 30%, a recession followed. While there is much PTSD associated with the word “recession”, it may be worth noting that this may not lead to complete turmoil this time around. The Fed’s willingness to adopt monetary policy easing also suggests an added cushion is being prepared for the economy’s inevitable correction.

But with rates already being lowered while the economy is still showing signs of health, what consolation is left for when a recession actually hits? Negative rates perhaps?