How to Interpret Federal Reserve Interest Rate Changes

The Fed lowered Fed Funds today by 50 bps to 5.0%. 11 of the 12 Fed governors backed the idea. They also shared their quarterly projections, targeting another 25 bps cut in November and 25 bps in December. So, if that holds, by year-end, we will have a 4.5% Fed Funds. For perspective, cutting rates usually is done to provide some financial relief in a struggling economic environment. The S&P 500 hit another record high on the news. The Fed policy statement said: "The committee has gained greater confidence that inflation is moving sustainably toward 2%, and judges that the risks to achieving its employment and inflation goals are roughly in balance." The 10y UST was at 3.64% on the news, up slightly from a 52-week low earlier this week. When the long end drops it can be a bearish signal as people are buying more bonds as a safety investment, pushing down rates. So you have the bond market signaling recession while the stock market is signaling that all is well. What a moment. I must admit I have a hard time reading the tea leaves on this one. Why did they cut 50 and not 25? Perhaps they know something I don't (and go ahead, make a joke, I'm an easy target!). Perhaps they are worried about the interest payments being the 2nd biggest line item in the Federal budget. But seriously, a 50 bps cut feels to me like a crisis cut. This is a policy change moment, to be sure. We all knew it was coming because Powell telegraphed it for months, especially at Jackson Hole. But the economy is doing very well, and top-line macro indicators look good. It is two months before a major presidential election where the incumbent is out of the race. To the point about inflation being subdued, I would be remiss if I didn't point out that housing prices are up 6.7% YoY as of August, which, granted, is lower than previous prints, but is still well elevated. Housing prices are the biggest component of the Core CPI. We are all living with the consequences of astronomical increases in housing prices. Perhaps the Fed thinks that by lowering Fed Funds this much, it could jump-start supply in the housing market, bringing people off the sidelines to sell, and to buy, potentially lowering prices as an equilibrium is found. I don't know. With this move we should expect to see a mini-boom for gold prices. Gold started the year at $2000, and now it's $2600 an ounce - a 30% increase YTD. The "barbarous relic" has for thousands of years been a safe-haven investment. Could be a driver of its bid. I'll have more to say about this move in the coming days. Need to think about it. But I am surprised they cut 50 and not 25. #fedpolicy #riskmanagement #interestrates

The Federal Reserve’s half-point cut in the Federal Funds Rates signals both the end of its fight against high inflation and a renewed focus on supporting the labor market. Chair Powell’s speech in Jackson Hole last month previewed this shift toward protecting the labor market, and those words are now turning into action. Powell and other policymakers openly acknowledged the risks to the labor market are growing, with 12 participants indicating unemployment risks were increasing, up from only 4 in June. The median projection for the unemployment rate for the end of this year and 2025 increased to 4.4%, from 4% and 4.2% earlier this year, signaling the Fed expects the labor market to soften further. With inflation trending toward 2 percent, a smooth landing can happen if actual data comes in as projected. But whether or not the pilot lands the plane skillfully depends on whether the pullback in interest rates is large enough and quick enough. The descent is going well so far, but the plane is not yet on the ground.

It's no secret that I have been expecting a 50 basis point rate reduction at the upcoming FOMC meeting (September 18). Here are a few additional thoughts ... The Fed can either decide to tighten financial conditions or not. The futures market is currently pricing a 59 percent probability of a 50-basis point rate cut. Thus, unless something changes, going 25 will tighten financial market conditions, pushing interest rates up. Monetary policy works through the financial markets. Tighter financial conditions should be avoided when the balance of risks between growth and inflation have shifted as they have now. If the downside risks to employment outweigh the upside risks to inflation, then the Fed should be leaning against tightening financial conditions, all else equal. What are the chances of a hawkish 50 basis point cut? Powell may be successful in pushing through a 50-basis point rate reduction, but the projections show only a total of 75 basis points of rate cuts for the entire year. That would imply officials see only one more cut for the year, a hawkish sign. I am skeptical this will matter in the end. A “hawkish 50” is as unlikely as a “dovish 25.” In the former case, the dots will not be that significant. Powell will use the press conference to downplay them and stress these are conditional estimates. I am always reminded of what Yellen said back in 2014: “I think that one should not look to the dot plot, so to speak, as the primary way in which the Committee wants to or is speaking about policy to the public at large.” This is one reason I think going 50 or 25 is important. A popular argument goes like this: because many cuts are priced into the market the size of the move this week is not that important. I get it but believe this understates the significance in a few important ways. For one, the Fed’s policy rate is linked to prime rates. It’s the Fed’s rate not expectations that determine small business loans and auto loan rates, for example. Next, a big upfront move is a signal that the Fed means business about getting back on sides while a 25-basis point move with rates still far from neutral implies they are willing to leave a restrictive policy in place for a long time. 

Cutting Deeply or Just Enough? Today, the Federal Open Market Committee (#FOMC) cut its short-term #interest_rate by half a percent or 50 basis points. Some might consider this a cut too deep. Certainly, it is different from what many, including myself, expected. A 25-basis-point cut would have been safer, but less powerful. However, it might not have been sufficient as inflation fell. Lower inflation means a higher real interest rate. First, the cut means the benchmark federal funds rate will be between 4.75% and 5%. We are talking about a 10% relative change instead of a 5% one. It looks large but might not be as significant in investment terms. Many argue that the Federal Reserve succeeded in controlling inflation with an aggressive monetary policy. Now, it is time to maximize employment, as some argue. Since 2022, the Federal Reserve has been increasing the interest rate to control inflation. In less than two years, it increased the interest rate from 5.25% to 5.5%, making borrowing more expensive. The average American consumer paid more in interest on his/her credit card debt, and businesses borrowed at a higher rate. The Federal Reserve's challenge is to cut the interest rate to encourage employment without flaming inflation. The housing market is the perfect place to observe the double impact of a rate cut. Many potential homebuyers have been waiting for a drop in interest rates to borrow a mortgage at affordable rates. However, if mortgage rates do not decline enough, their savings won't be meaningful. If the rates decline too much, the demand for housing increases so much that an increase in housing prices would swallow any significant fall in the cost of borrowing. The Federal Reserve has cut interest rates in a way that encourages homebuyers to start looking again without encouraging too many to buy houses. People will shop for their first home but not the second or third investment properties. This is only the first cut in the interest rate. By increasing the predicted unemployment rate to 4.4% from 4.2%, the Federal Reserve is also sending a signal about the future. The inflation might be under control, but it is time to pre-empt any potential increase in unemployment. The graph is from The Wall Street Journal. #HousingMarket #Prices #HousingPrices #Mortgage