While financial markets grapple with the impacts of this week’s interest rate decision from the US Federal Reserve, what matters more is how markets got to this point and how this will impact the next three-to-six-month window.
The Fed announced a rate cut of 50 basis points on Wednesday, lowering the target range for the federal funds rate of 4.75 to 5 per cent.
At the Top1000Funds Fiduciary Investors Symposium at Stanford University, just hours before the Fed’s decision Bridgewater Associates portfolio strategist, research group, Alex Smith tipped a cut but noted the real consequence would not be the specific decision the Fed made, but how markets had arrived in this position.
“I don’t think it matters,” Smith said.
“I guarantee they’re going to cut. Is it going to be 25 [basis points]? is it going to be 50, 37.5? I don’t know. What’s really interesting is how are we in a position where I can guarantee you they’re going to cut.”
He noted that almost 17 years ago to the day, the Fed cut 50 basis points ahead of the Global Financial Crisis, and he questioned whether it had any impact in the following months.
But looking at the situation now, the focus is on why the Fed cut, what the implications are, and what it effects it will have. “That’s the next three to six months,” Smith said.
“But then stepping back, how is that similar to and different to what we’ve experienced before? There are some similarities – old-school interest rate policy; we call it ‘monetary policy one’.
“[This is] the traditional way we learned how the Fed operated, but with a twist and that twist is what we call ‘monetary policy three’ which is what we call fiscal policy. These two things are operating at the same time and it’s going to create a pretty different backdrop for investors.”
When rates are lowered to stimulate the economy during a downturn, it typically leads to greater borrowing, and that borrowing produces spending.
“One person’s spending is another person’s income, and you get the cycle going,” Smith said.
“It leaves a residue and that residue is debt. The debt went higher and higher and higher and the debt itself was a deflationary force. That’s why inflation is going down and it reached a level in 2008 where private sector debt was very high.”
It was then that the Fed sent interest rates to zero, to no response, which Smith likened to an emergency ER doctor using a defibrillator on a patient with no effect.
A different regime
Instead, the Fed went to a different policy regime – dubbed ‘monetary policy two’ – which involved printing money to pump into the financial market instead of stimulating borrowing by lowering interest rates.
“A very different form of stimulation, it produces asset inflation – not much in the way of goods and services inflation – and it very indirectly kind of leaks into the real economy,” Smith said.
Smith posited a twofold justification for the decision to pursue this method: first, because inflation was already low; and second, because, ultimately, “they had to”.
“They were the only game in town,” he said.
“There wasn’t much in the way of fiscal stimulation, but by the end of the 2010s it became apparent you were going to need more fiscal [policy] to get additional stimulation.
“What catalysed that I don’t think anyone predicted, which was the pandemic. You had a rapid decline of economic activity and coordinated money printing and fiscal easing.”
The fall out of the Covid-19 pandemic led to multiple trillion-dollar stimuli which targeted support for consumer incomes.
“Those incomes were spent – one person’s spending is another person’s income so that was good,” Smith said.
“You got good income growth but there was a residue, the excess demand. There was too much demand and the economies that stimulated more had more inflation and that led the Fed to eventually recognise it was not transitory.
“We’ve got to tighten, move interest rates up 550 basis points, move QE [quantitative easing] to QT [quantitative tightening] and then you’ve had this effect where inflation has come down.”
While Smith notes there are other factors that have driven down inflation – like the resumption of functional and undisrupted supply chains – the economy is now in a position where inflation has come down closer to target but it’s beginning to create weakness in the labour market.
“They want to get in front of it, that’s why they’re easing today because there are the effects where this has slowed inflation, but the tightening is slowing spending in the real economy,” Smith said.
But Smith conceded the reason everyone is “obsessed” with these three monetary policy frameworks is because ‘monetary policy one’ is the goal for central banks, but elected officials prefer ‘monetary policy three’.
“So that’s a tension,” Smith said.
“It’s one thing if you want to have record deficits and the central bank’s printing money and basically handing it to you, it’s another if you’re moving in opposite directions.”
The good news
The good news, Smith said, is that this is different to the GFC. In 2008, defaults on subprime mortgage debt directly drove the crisis, but private sector credit hasn’t played a role in the economic expansion for the last few years.
“Is it like 2008? It’s not, that’s good the news,” he said.
“The big support was fiscal stimulation and very strong labour markets – now those are rolling off and the Fed has to offset it.”
“That’s mid-cycle easing. Mid-cycle easings are great for everyone in this room, if you’re an asset owner. Now there’s two flies in the ointment: we don’t know if it’s a mid-cycle easing and you don’t know until afterwards; and this could easily be wrong.”
Smith added there “is a lot of good news priced in” which has meant higher asset prices and lower forward-looking returns.
“When we look at the momentum of the conditions it looks like we’re probably more in the foothills of a bubble than the top of a downturn and you could see rich assets get richer still,” Smith said.
“We’ve all been conditioned to that; you haven’t had a prolonged drawdown in 15 years. That’s in the US where we’re generally probably more of a mid-cycle easing, much more favourable for asset holders than entering a recession with a lot depending on not how much they cut today, but how much do they cut, and do you get the [economic] response?”
