Broker Check

Data should have moved the Fed away from a rate cut

August 06, 2019
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I am not sure I understand why the Fed is acting the way they are. I am confused with their rhetoric.  For the past several years, under the leadership of both Jerome Powell and, before that, Janet Yellen, the Fed claimed it was "data dependent." That means that they act on data and nothing else. That is exactly why weeks ago I said they were irrelevant.
The decision last week to reduce short-term rates by 25 basis points tore their "data dependent" narrative to shreds. At the prior Federal Reserve meeting in mid-June, a slender majority of Fed policymakers projected no rate cuts this year. After that, the data flow on the economy was generally better than expected, including solid reports on jobs, retail sales, manufacturing production, and real GDP. These figures undermined the Fed's forecast that real GDP would grow only 2.1% this year.

 In addition, both consumer and producer prices rose more than expected. If the Fed were truly data dependent then, if anything, this data should have moved it away from a rate cut. The oddest part of the Fed's decision was Powell acknowledging how little it's rate cut means. "(W)e don't hear that from businesses. They don't come in and say we're not investing because...the federal funds rate is too high. I haven't heard that from a business. What you hear is that demand is weak for their products."

 And yet, the US consumer looks pretty strong. Core retail sales, which exclude volatile items like autos, building materials, and gas, are up 4.4% from a year ago and up 10.6% annualized so far this year. Powell said at the press conference following the meeting that the Fed wants to "ensure against downside risks to the outlook from weak global growth and trade tensions." Yes, Europe and China have experienced slower growth. But some of the slower growth abroad, particularly in China, is a result of changes in trade policy so that the US no longer subsidizes China by turning a blind eye to that country's piracy of intellectual property. And slower growth in Europe is largely a function of structural issues that US monetary policy can't solve: too much redistribution, too much regulation, too much socialism.

Moreover, it's not clear that slower growth overseas is a negative for the US; some of the slower growth abroad is because tax cuts and deregulation have made the US a better place to do business. Maybe the Fed thinks very low long-term rates are, in part, a function of weak expectations of future growth (regardless of today's solid growth) and that if short-term rates stay above long-term rates, then eventually businesses and consumers will have an incentive to postpone economic activity because short-term rates will eventually move lower, as well. But if that's what the Fed thinks then deciding to cut rates only 25 basis points might have been the worst decision it could have made. If the Fed didn't cut rates at all and the Fed's statement and press conference focused on the bright side of the US economy, it could have spurred an increase in long-term interest rates that would help unwind the inversion of the yield curve. (Long rates lower than short rates.) Or, as an alternative, the Fed could have cut rates more drastically, in the 50-100 bp range, to make sure short-term rates go below long-term yields,and then make it clear in the statement that the Fed was simply reacting to the yield curve and that the prospects for the economy remain bright. Instead, by reducing rates only 25 bp and letting the markets assume further rate hikes ahead, it did very little to end the inversion.

Our view remains that last week's rate cut wasn't needed, nor are further rate cuts in the months ahead. Nominal GDP is up 4.0% in the past year and up at a 5.0% annual rate in the past two years. Gold is up 12.3% so far this year. There are plenty of excess reserves in the banking system. The Fed is not tight. At a deeper level, we think the Fed's recent flailing is an inevitable result of the experiment that began during the Panic of 2008 when it started paying banks interest on reserves. The Fed then shifted to implementing monetary policy by directly targeting interest rates rather than managing the supply of money and deciding what short-term interest rate was appropriate given its target for the money supply. Either way, it looks like the flailing Fed is headed for another rate cut at the meeting in September. The Fed is under enormous pressure to reduce rates, both political and from the bond market. Maybe that's why it's having so much trouble articulating a rationale. Eventually, inflation will rise as a result. In the meantime, equities remain very cheap.

Aside from the Fed not giving the markets what it asked for-a big rate cut and the promise of further rate cuts- the markets also had to contend with new escalations in the trade war between the US and China. Last week, the US sent a trade delegation to China for a round of negotiations. As the meeting broke up, rather quickly, both sides said it had been "constructive" and that they were planning on meeting again in September in the US. Most investors took the news as establishing nothing new, either good or bad. However, President Trump surprised the global markets with the announcement that all of the remaining goods the US imported from China would be subject to a 10 percent tariff starting on September 1st.

Equity markets in the US and around most of the world declined last week as they endured a one-two punch from the US Fed and President Trump. What started as a very slow week with investors actively anticipating a Fed rate cut and hoping Chair Powell would signal further cuts quickly deteriorated when investors felt let down by the Chairman's press conference. Adding fuel to the fire, as mentioned above, was President Trump's seemingly random attack on China through the imposition of another round of tariffs slated to start September 1st. Overall volume was not very high in light of the size of the market movements with only the Russell 2000 and the S&P 500 getting to the average weekly volume levels that we have seen over the past year.
 
○ Dow (-2.60%) - Below Average volume
○ Russell 2000 (-2.87%) - Average volume
○ S&P 500 (-3.10%) - Average volume
○ NASDAQ (-3.92%) - Below Average volume

Source : Monday Morning Outlook 8-5-19: Callahan Capital Management Weekly Commentary 8-5-19
Source : Monday Morning Outlook 8-5-19: Callahan Capital Management Weekly Commentary 7-29-19
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