The Federal Reserve’s recent dramatic shift from tightening to implied loosening is the fastest shift of Fed behavior in 50 years. Some people have leapt to the conclusion that Fed chief Powell simply caved into pressure from Trump, betraying good hard money policies, and changed to easing because of Trump. The real reason for the easing is because Fed employees have researched and realized that the Fed and other central banks made many mistakes, including being too optimistic about economic recovery since the crash of 2008, so they want to be truly prepared for the coming recession.
It is highly likely that economic cycles can’t last more than ten years. The current cycle was modestly extended by Trump’s tax cut of 2018 but the effects of that cut wore off around the 4th quarter of 2018. The SP index lost 4% including dividends in 2018, so even with stimulus it wasn’t enough to save stocks. The momentum of stocks has been broken. This is crucial because the stock market increase since 2012 has mainly been based on technical trading things like momentum or behavioral changes like accepting higher PE multiples, rather than on earned fundamentals. Basically the market didn’t really earn the right (based on fundamentals) to go up much after 2012, instead it went up for unearned speculative mania reasons. Now that upward momentum has been broken then technical traders who are long stocks have become prepared to suddenly abandon ship which could lead to a sudden Flash Crash and a full-on bear market.
While it is good for society that the Fed has woken up to their mistakes and become self-aware of their errors, the fundamental problem for central banks is that rate cuts don’t work very well if debt balances are excessive. The problem with relying on Fed rate cuts to fix the economy is that economic decisions are not made merely because the interest rate is lower, but also because the total all-in cost of capital (where a hypothetical hurdle rate is used) is used to decide whether or not to expand a company’s plant, equipment and employees. Finance professor Aswath Damodaran said the interest rate is a much smaller part of the cost capital calculation than the total cost of capital.
Central Bank rate cuts are a weakly effective placebo because why should a business manager trust a cut in short term rates with no contractual protection against a sudden rise like the 300 basis point rise of Feb., 1994? The placebo can “work” if used to solve modest recessions where the economy is only burdened by modest amounts of debt. Once debt loads become gigantic and recessions have lasted for a long time then people impose a significant risk premium hurdle rate on top of the risk free reference rate and this resulting number is far too high to justify expanding a business. Ironically the worse things get, the more rates get cut by the Fed, yet the higher the market’s hurdle rate becomes. Thus the Fed doesn’t solve major problems. However, the Fed makes things worse by cutting rates excessively which robs retirees of purchasing power and consumer confidence, leading to a deflationary cutback in spending.
The Fed has merely become aware that they need to improve themselves and become self-aware of their weaknesses, but they haven’t grasped that excessive rate cuts actually make things worse. The bad experiences with central banks in Japan and the EU shows what may be the future of the entire global economy. Yes, it was a step in the right direction for the Fed to realize they made a mistake tightening in 2018, but they need to acquire a much greater self-awareness that rate cuts don’t work and actually damage a source of much-need demand in terms of retiree and pre-retiree consumption.
The best solution, regarding rate cuts, is for the Fed to avoid shocking or disrupting people’s plans and to let the marketplace determine what is the equilibrium rate of interest. The Fed’s misbehavior raises the risk premium charged by the Invisible Hand of the market for capital projects, actually making things worse when the Fed cuts rates inappropriately. Once retirees and pre-retirees gain more consumer confidence, as a result of earning a decent yield, they can boost spending, thus creating more demand. The phrase pre-retirees means people who are planning on saving for retirement and who seek to estimate what the future yield from their portfolio will be. If it is projected to be too low they will refuse to retire, thus creating a shortage of job openings for young people, thus driving down wages, and creating a deflationary spiral.
If there is excessive inflation and the Fed tightens, this is not a placebo; it will work. It did during the 1979-86 Volcker era. However, if the Fed loosens, especially if debt levels are too high, this won’t lower, but will actually raise the cost of capital. When QE started, rates rose; when it ended, rates declined.
The Fed has two great strengths: Volcker era inflation fighting and the ability during a banking crisis to print up money and aggressively, instantly rescue financial companies like Bear Stearns, AIG, etc. The mistake people make is they leap to the conclusion that because Fed money printing that can rescue a financial company that it can also rescue aggregate demand, consumer confidence, or lower the cost of capital – it can’t, and actually makes things worse. Perhaps hypothetically fiscal policy stimulus can work, but monetary policy doesn’t work because the increased money supply is simply squandered on asset bubbles instead of use to fund new plant and equipment. Monetary policy that cuts rates excessively also leads to undermined and failed financial institutions: how can insurance companies survive with negative interest rates plus their overhead costs? Thus a regime of negative rates would lead to Depression. And it leads to failed retirement plans, assuming that ultimately a desperate gamble in risk-on assets ends in disastrous losses and that bond yields are too low.
Investors need independent financial advice about central bank policies.