by Hubert Marleau, Market Economist, Palos Management
September 20, 2024
The Federal Reserve boldly decreased its policy rate by 50 bps to the 4.75%-5.00% range, deviating from its traditional quarter-point pace of adjustments and signalling that another 50 was possible before 2024 ends, including another 100 bps next year. This announcement, which finally ends the tightening cycle, raises the question: why did the Fed opt to begin with a bang, cutting interest rates big time when the economic growth is thriving and inflation has not yet officially reached the Fedsā own 2% target?
Indeed, NowCasting models are predicting that the US economy will advance 2.9% in Q3 and by another 2.7% in Q4. Moreover, U-7, which measures the number of part-time workers who want full-time jobs as a percentage of the workforce, has not risen as fast as the unemployment rate, suggesting that the most fragile element of the labour market is not as soft as intuitively believed. This would explain surreptitiously why the number of new claims for unemployment benefits are uncommonly low, falling again last week by 12,000 to 219,000 without any contraction in employment. As a matter of fact, the Citi Economic Surprise Index shows that since mid-July negative surprises have eased off as more and more data points have moved to the upside.
Acknowledging that central banks are guided by the Brainward principle - if youāre uncertain, go slow - the fact that the monetary authorities went big means that they were probably sure that high inflation has been whipped. Consequently, investors openly received the direct answer they sought. Based on its own research and analysis, the Fed decided finally, from a risk-management perspective, to introduce a mid-course recalibration of its monetary stance and to cancel for good its emergency levels of monetary squeezing in favour of laying the groundwork to preserve the ongoing normalization process.
In this connection, the monetary authorities intend to bring the policy rate (4.875%) more in line with where the neutral rate stands at 3.50%, in order to unwind the tightening. Thus the removal of the emergency level of monetary squeezing has significantly improved the odds of a soft landing, which sparked a furiously global rally in stocks, pushing the S&P 500 on Thursday to a new all-time high of 5714, which only backed off a bit on Friday to register a weekly gain of 1.4%.
According to 81% of the respondents to a Bloomberg survey conducted on September 18, 81% of them believed that the rally will continue. Investors have manifested their willingness to pay up now for future profits because the action of the Fed had reduced effectively the discount rate with its rate cut - not because the employment situation is bad but because productivity is good. Nonetheless, stock prices could dip this week. The CBOE SKEW index, a measure of potential risk in financial markets shot up to 166 on Friday, too high for comfort. Bear in mind that recent history shows that dips represent opportunities to buy good companies cheaper.
Incidentally, it seems as if the Fed has a lower estimate of the neutral than I, setting it at 3.00%. My higher estimation of 0.50% is based on the notion that the character of the economy has undergone a structural shift away from excess savings toward higher investment (think excessive government spending deficits, ageing demographics, massive immigration, lower fertility rate, high degree of resource utilization, defence spending geopolitical economic warfare, national security concerns spurring national defence expenditures, rising productivity growth, the capital cost of AI, and disintermediation of the financial system). On the latter point, Iām not surprised that Powell said that the Fed was not declaring āmission accomplishedā, delivering instead a rather hawkish message, revealing it was in no rush to lower rates. Heās right that the exact position of the neutral rate is a critical unknown: it can only be estimated. Perhaps, this is the reason why Powell chose to be prudent.
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