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These growth rates suggest short-term interest rates should be higher, not lower!

These growth rates suggest short-term interest rates should be higher, not lower!

March 03, 2020

By the time you read this, the Fed has already have cut rates by 1/2 %. That is the situation we find ourselves in given the recent correction in equities, which were at a record high only eight trading days ago but were down 12.8% from that peak as of the market close on Friday. Fears about the economic effects of the coronavirus have driven equity prices lower and led to calls for the Federal Reserve to cut rates. 

But we think a rate cut – any rate cut – is a mistake. Nominal GDP – real GDP growth plus inflation – is up 4.0% versus a year ago and up at a 4.4% annual rate in the past two years. These growth rates suggest short-term interest rates should be higher, not lower. If people become less productive because they’re scared of getting sick, lower interest rates won’t change that. Part of the problem is that the Fed spent much of 2019 agonizing over potential trade wars and Brexit, resulting in three rate cuts of 25 basis points each. Yet, in the end, key trade agreements were reached and Brexit didn’t tank the UK economy, much less hurt the US. The Fed didn’t need to cut rates last year and shouldn’t now. 

However, the Fed has done so. That’s the upshot of Fed Chairman Jerome Powell’s Friday statement that the virus “poses evolving risks” the Fed is “closely monitoring developments,” the Fed will “act as appropriate to support the economy.” Clearly, a rate cut isn’t going to be able to cure a virus. However, the Fed believes that the higher asset prices that may result from lower rates will generate a “wealth effect” that boosts consumer spending and underpins demand. The cut was made this morning and the markets are down. Why? Because the Fed has said through the rate cut that the coronavirus is worse than thought and that has the markets spooked. 

The Fed did not go far enough. We think it should have gone much bigger. Instead of trickling out measly little rate cuts of 25 bp each at the next few meetings or even the half point that was announced this morning, the Fed should cut rates by something like 75-100 bps all at once on or before March 18. The key is that the Fed would then pair that one big rate cut with a statement, a “dot plot,” and a press conference that shows the Fed is committed to lifting rates back up once we’re past the economic fears related to the coronavirus. 

The problem with the drip, drip, drip approach is that if the Fed cuts rates only 50 bp while the market expects more rate cuts later on, it incents households and businesses to postpone activity and decisions. Why act now when we all know rates are going even lower? Again, the best option is doing nothing; monetary policy isn’t a flu vaccine and rates, as low as they are already, are not an impediment to economic growth. But if the Fed is ready to act, decisive would be much better than wishy-washy. Oh well, we will see in the next week or so if this rate cut had any effect. So far, it wasn’t enough to move the markets up.

Equities: As referenced numerous times above, the US equity markets had one of their most difficult weeks that we have seen over the last 30 years. Volume went through the roof on all four of the major indexes with a few days seeing near historic trading levels. The indexes stopped very close to a few key technical retracement levels, so it will be interesting to see if the indexes can manage to hold those levels throughout the next week.


○ NASDAQ (-10.54%) – Above Average volume 

○ S&P 500 (-11.49%) – Above Average volume 

○ Russell 2000 (-12.04%) – Above Average volume 

○ Dow (-12.36%) – Above Average volume

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