Lets do what so many self-described free-market thinkers won’t; believe the market is smarter than a few, very human folks at the Fed. A now-decisively inverted yield curve is the bond market “telling” the Fed it needs to cut short-term rates.
Cutting rates should re-draw the yield curve by pulling down the left side of the line (short-term rates) and cranking up the right side (long-term rates). That will be perceived and experienced as a stimulus. Markets will rip and etc. etc. If the Fed doesn’t cut rates, we risk a recession. The market is telling us cutting rates is the right thing to do.
If the market is right, why is the Fed is shuffling its feet? Partly because today’s economy seems so strong and unemployment so low (present situation bias). Partly because it fears future impotence (“impotence” just is not a happy word). So does the Fed ultimately choose action or inaction?
- If the Fed acts by inaction. The yield curve tells us we’ll have a recession sooner versus later. When it comes, the Fed will fire all the bullets in its policy weapon. That intervention will likely prove inadequate.
- If the Fed acts by cutting rates. This defuses the immediate recession risk. The economy probably ticks along nicely for a while – tariff threats notwithstanding. But the Fed unloads most of its policy ammunition. Leaving the Fed powerless when some future shock tips us into a recession.
Whichever path the Fed takes, we end up (faster or slower) in the same place. Out of bullets on conventional monetary stimulus. Wallowing in a downturn or possibly spiraling into a deeper depression. Unable to deploy the weapon of (meaningfully large) fiscal stimulus; politically hog-tied by 30-40 years of faith-based rejections of “wasteful government spending” in any guise at any cost.
Eventually our politics would change enough to substitute fiscal stimulus for monetary stimulus. But remember that means turning over the Senate, not just the White House. Call me in 2024?
There is a a third possible scenario if the Fed cuts rates quickly now. Something somehow somewhere (gasp) sparks some decent (3%-4%) inflation. The economy “overheats.” That is serious-people-Fed-speak for workers regaining bargaining power and clawing wage gains back out of cash flows currently shifted to record-high profit margins. Debt risks diminish as inflation eats away at now-low-real-rate mortgage and bond obligations. The strong economy auto-reloads the Fed’s policy weapon as inflation pushes nominal interest rates ( real growth + now-higher inflation) back to more normal 5%-7% levels. Everyone lives happily ever after. Even the anti-government spending crowd wins in the same way as anti-vaxxers that manage to avoid the reality of a measles epidemic – they don’t even have to question their own faith-based delusions.
I’m worried the Fed doesn’t cut rates. Pretending they are smarter than the markets. Tipping us into a self-inflicted, unnecessary recession. Why? Because cutting rates leaves the Fed powerless to intervene in the future. “Powerless” isn’t a word any institution willingly embraces. Although “recession” isn’t a great word either – especially if it improves the chances of anti-bank-crusaders Elizabeth Warren or Bernie Sanders in 2020. It’s a tough choice, but reality is a tough place.
Absent rekindled inflation, we’ve seen this movie before. In Japan. It’s a long slow slog without much drama to enliven the misery. So really, most people haven’t really seen this movie before (myself included). The Japan story was a depressing financial widow-maker that played out to a shrinking, now-tiny audience. Most people read the (terrible) reviews and stayed far far away. I think that is why I’m finding it so hard to find much decent English language insight on Japan’s last 20-30 years. Even though it might foretell our next 20-30 years.
We’ll know about the Fed’s decision in the next 6 months.
- If they don’t cut rates, we have a clear and present danger.
- If they do cut rates, we watch (and hope) for inflation, but plan for something far worse. Maybe a crash course in modern Japanese economic history (ugh).
In this post, I’m going to assume you’ve read my post linking to the excellent NYTimes article explaining our out-of-whack interest rate environment. If you haven’t, swing over and give it a skim. We’ll wait. Just don’t wander off to that click-bait cat video mid-way through.