Understanding Why the Fed Cut 50 Basis Points
“What changed between July and September?” That was a question asked a lot after the Fed cut 50 bps last week, seeing as at the July meeting Powell stated that a 50-bps cut “wasn’t something we’re considering right now.”
I want to take a moment and address that question because it’s important we understand why the Fed cut 50 bps and, if this logic holds, the Fed will keep cutting aggressively. Essentially, what changed over the past six weeks is that the Fed became more convinced that the inflation spike of 2021-2023 was largely caused by supply chain impacts of the pandemic and, to a lesser extent, the increased stimulus and deficit spending we saw from Washington during those periods.
Here’s why this matters: All of those are now gone. And now that they’re gone, inflation is very quickly returning to the Fed’s 2% target. But the Fed still has rates where they were during the inflation spike. Put more informally, I believe Fed members are asking themselves: “If inflation was caused by the pandemic, stimulus and spending and all those are gone and inflation is quickly falling back to 2%, then why do we have rates so high?”
Now, let me put this logic to actual numbers to further illustrate the point. For reference, we’re going to use Real Interest Rates as a measure of the headwind the Fed thinks is appropriate on the economy. Now, let’s go back to before the pandemic. The Fed had just executed a rate cut in the summer of 2019 to help the economy and Real Interest Rates in August 2019 were around 75 basis points. The Fed kept cutting into the end of that year to support the economy and Real Interest Rates fell to essentially 0%.
Then, the pandemic hit, and the Fed cut rates to zero percent and kept them there for two years. The Real Interest Rate hit a low of -3.25% in February 2022, right before the Fed started its rate-hiking cycle. Over the next year and a half, the Fed dramatically hiked rates and kept them there while inflation rose and then fell. From that low of -3.25% in February 2022 Real Interest Rates rose to a high of 3.47%, hit just over a week ago.
Now, with the Fed’s last rate cut, Real Interest Rates are sitting at 3.00%. Here’s the important point: The last time inflation and the economy were “normal” was mid-2019, before the pandemic. In summer 2019, Real Interest Rates were about 1%, before the Fed started it’s rate cutting cycle.
Now, the Fed would argue that inflation and the economy is back to “normal” but real interest rates are still 3.00%. To use a simple analogy, it’s like we’re in a car going down a steep hill. The Fed had to ride the brakes going down the hill to stop inflation and make sure the car didn’t get out of control. But now the economy is back on a flat road (normal) and the Fed is still riding the brakes. If they won’t let off, the car will stop (recession).
This matters because if I am right about the Fed’s logic, then it is possible the Fed has made its second policy mistake regarding inflation. The first policy mistake was believing inflation was transitory for too long and not hiking rates. The second policy mistake may be not believing inflation was transitory and keeping rates high for too long. I’m not saying that’s going to happen, but that seems to me the motivation behind these aggressive cuts, and it reinforces to me that while the market has convinced itself the Fed isn’t behind the curve, the risk of that may be greater than the market currently anticipates.
So the only thing standing in the way of a sound economic policy is the elections. More on that in future commentaries.
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