A version of this post first appeared on TKer.co
The calls for the Federal Reserve to begin cutting interest rates sooner than later have been getting louder.
The resistance to these calls seems to be the suggestion that an initial rate cut would represent some monumental dovish shift in monetary policy at a time when concerns about inflation haven’t been fully put to rest.
But it’s not obvious to me that one rate cut is so big of a deal that it warrants some extraordinarily high hurdle for it to happen, especially with economic activity trends cooling.
‘Get on with it’
Inflation metrics have been coming down for two years and are now at levels that are just a rounding error away from the Fed’s 2% target rate.
Meanwhile, economic activity growth has been decelerating significantly, with labor market metrics normalizing. The economy has been looking a lot less “coiled,” with many signs of excess demand fading.
“Previously, with inflation far from its objective and employment closer to its objective, the Fed’s focus was on inflation,” BofA’s Michael Gapen said on Thursday. “Now, with smaller deviations in inflation and employment from target, the Fed’s attention can be more balanced. Cuts can happen because the economy cools, because inflation slows, or both.”
The risk of recession has been rising with economic growth slowing. Consumer spending growth plateauing and debt delinquencies rising are among the emerging warning signs. Notably, the unemployment rate has been ticking higher.
Taken altogether, it’s not surprising to hear Fed watchers argue for a rate cut.
“Get on with it,” says Renaissance Macro’s Neil Dutta, who has been out front among his peers with this call.
The Fed’s Federal Open Market Committee (FOMC) meets for its monetary policy meeting this coming Tuesday and Wednesday. While it’s unlikely that the central bank will announce a rate cut at the conclusion of this meeting, it may use it to signal future changes in policy.
“The Fed is getting closer to begin recalibrating monetary policy,” Dutta wrote in a note to clients on Monday. “Recent commentary strongly point to a September rate cut with July’s meeting being used to prep the markets that a series of cuts are on the horizon.”
Dutta isn’t alone in his call for the Fed to begin cutting rates soon.
“Markets are almost fully priced for a cut at the September 17-18 FOMC meeting, which remains our baseline forecast,” Goldman Sachs’ Jan Hatzius said earlier this month. “But we see a solid rationale for cutting as early as the July 30-31 meeting.”
Even former NY Fed President and longtime hawk Bill Dudley has made the case for a July rate cut.
“The Fed should cut, preferably at next week’s policy-making meeting,” Dudley wrote on Wednesday. “Although it might already be too late to fend off a recession by cutting rates, dawdling now unnecessarily increases the risk.”
While he hasn’t explicitly said anything about cutting rates in the coming months, Fed Chair Jerome Powell has recently acknowledged the growing risks to the economy.
“[I]n light of the progress made both in lowering inflation and in cooling the labor market over the past two years, elevated inflation is not the only risk we face,” Powell said in his testimony to Congress earlier this month. “Reducing policy restraint too late or too little could unduly weaken economic activity and employment.”
Monetary policy is not a light switch
While a first rate cut is arguably a historic milestone in the Fed’s fight to end the inflation crisis, I’m not convinced it’s as explosive of a market event as some pundits imply.
“I don’t think monetary policy is a ‘light switch,’” Dutta explained on CNBC. “It’s not on or off. The Fed can be nimble and flexible.”
I like this characterization because it addresses a nuance ignored in many discussions about rate cuts.
And I’ll take Dutta’s analogy a step further and say monetary policy is a “dimmer switch.” If your lights are on full power and you dim them by 5%, they’re still pretty bright, right?
Now take the Fed’s 5.25% to 5.5% target range for rates and cut it by 25 basis points. You get a range of 5% to 5.25%. Sure, that would mean monetary policy is a little less tight. But it certainly can’t be characterized as loose monetary policy.
With inflation mostly under control and economic data deteriorating, what’s the harm in dimming monetary policy a little? There’s arguably more upside than downside.
Frankly, I think all the concerns about a first rate cut are overblown. As I argued in the January 28, TKer:
First of all, we’re talking about a potential 25-basis-point cut from a range of 5.25% to 5.5%. Sure, that’s not insignificant. But that’s nowhere near as big a deal as it was when we were talking about 25-, 50-, and 75-basis-point rate hikes from near 0%.
Second, all those big rate hikes early in the hike cycle were happening amid an intensifying inflation crisis. The economy was a complicated mess in 2022. Today, that crisis is largely behind us with inflation rates hovering near the Fed’s target levels…
In other words, the stakes for the upcoming Fed policy meetings aren’t nearly as high as they were in 2022 and 2023.
In March 2020, when the Fed cut rates by 150 basis points to effectively 0% as the economy was falling apart, that was a big deal.
Compared to monetary policy actions during more troubled times, cutting by just 25 basis points today just doesn’t seem like that big a deal.
Keeping historical context in mind, it may be advisable for the Fed to explicitly downplay the significance of a single rate cut and manage expectations for what a cut means for policy down the road.
“[W]e think Powell should and will avoid describing the first rate cut as consequential, as this conveys a sense of a series of rate cuts coming, which is the opposite of data dependent,” JPMorgan’s Michael Feroli wrote on Friday.
One rate cut may or may not bolster growth a little. It may or may not cause inflation to tick up a little. Who knows? But it’s hard to imagine a single rate cut going down in history as some massive policy blunder.
Zooming out
Maybe it’s the inevitable expectation that a first rate cut means that many more rate cuts are coming, and that’s what eventually moves inflation and other metrics in unfavorable ways. Well, then maybe the Fed will reverse course after the initial rate cut. As Dutta says, monetary policy is not a light switch, and the Fed has room to be nimble.
As far as the outlook for the stock market is concerned, history shows mixed results after an initial rate. Though, the 12-month price performance is less favorable when the Fed is cutting into a recession.
If the economy were to hold up following a first rate cut, then history suggests the outlook for stocks is positive.
Check out this chart from Ritholtz Wealth Management’s Callie Cox, which shows the 12-month performance of the S&P 500 following first rate cuts since 1970.
“It doesn’t look like we’re in a recession — or even close to one,” Cox wrote. “If history proves correct, we could see the stock market continue to move higher in a slow, grinding fashion.”
What the Fed does or doesn’t do in its upcoming policy meetings is sure to come with some kind of a market reaction. This can be said about most developments in the markets.
However, a 25-basis-point cut from a range of 5.25% to 5.5% seems pretty inconsequential relative to many of history’s other rate adjustments. And it would be a cut that comes as economic and financial market activity is relatively healthy.
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Reviewing the macro crosscurrents
There were a few notable data points and macroeconomic developments from last week to consider:
Inflation trends need to cool more. The personal consumption expenditures (PCE) price index in June was up 2.5% from a year ago, down from May’s 2.6% rate. The core PCE price index — the Federal Reserve’s preferred measure of inflation — was up 2.6% during the month, matching the lowest print since March 2021.
On a month over month basis, the core PCE price index was up 0.2%, up from 0.1% in the previous month. If you annualized the rolling three-month and six-month figures, the core PCE price index was up 2.3% and 3.4%, respectively.
Inflation rates have a little more to go to get to the Federal Reserve’s target rate of 2%, which is why the central bank continues to indicate that it wants more data before it is confident that inflation is under control. So even though there may not be more rate hikes and rate cuts may be around the corner, rates are likely to be kept high for a while.
Gas prices tick up. From AAA: “Barely budging since June, the national average for a gallon of gas squeaked out a two-penny increase to $3.52 since last week. The national average has hovered around $3.50 per gallon since June 26th.”
Consumers are spending. According to BEA data, personal consumption expenditures increased 0.3% month over month in June to a record annual rate of $19.44 trillion.
Adjusted for inflation, real personal consumption expenditures rose by 0.2%.
Card spending data is mixed. From JPMorgan: “As of 17 Jul 2024, our Chase Consumer Card spending data (unadjusted) was 2.2% below the same day last year. Based on the Chase Consumer Card data through 17 Jul 2024, our estimate of the U.S. Census July control measure of retail sales m/m is 0.20%.”
From Bank of America: “Total card spending per HH was down 0.3% y/y in week ending July 20, according to BAC aggregated credit & debit card data. Retail ex auto spending per HH came in at -0.8% y/y in week ending July 20. Online retail spending around Prime Day (including other retail promotions) appears to be tracking slightly ahead of 2023.”
Consumer sentiment worsens. From the University of Michigan’s July Surveys of Consumers: “Consumer sentiment has remained virtually unchanged in the last three months. July’s reading was a statistically insignificant 1.8 index points below June, well under the margin of error. Sentiment has lifted 33% above the June 2022 historic low, but it remains guarded as high prices continue to drag down attitudes, particularly for those with lower incomes. Labor market expectations remain relatively stable, providing continued support to consumer spending. However, continued election uncertainty is likely to generate volatility in economic attitudes in the months ahead.”
Unemployment claims fall. Initial claims for unemployment benefits declined to 235,000 during the week ending July 20, down from 245,000 the week prior. And while recent prints remain above the September 2022 low of 187,000, they continue to trend at levels historically associated with economic growth.
Mortgage rates tick higher. According to Freddie Mac, the average 30-year fixed-rate mortgage rose to 6.78% from 6.77% the week prior. From Freddie Mac: “Mortgage rates essentially remained flat from last week but have decreased nearly half a percent from their peak earlier this year. Despite these lower rates, buyers continue to pause, as reflected in tumbling new and existing home sales data.”
There are 146 million housing units in the U.S., of which 86 million are owner-occupied and 39% of which are mortgage-free. Of those carrying mortgage debt, almost all have fixed-rate mortgages, and most of those mortgages have rates that were locked in before rates surged from 2021 lows. All of this is to say: Most homeowners are not particularly sensitive to movements in home prices or mortgage rates.
Home sales fall. Sales of previously owned homes fell by 5.4% in June to an annualized rate of 3.9 million units. From NAR chief economist Lawrence Yun: “We’re seeing a slow shift from a seller’s market to a buyer’s market. Homes are sitting on the market a bit longer, and sellers are receiving fewer offers. More buyers are insisting on home inspections and appraisals, and inventory is definitively rising on a national basis.”
Home prices ticked higher. Prices for previously owned homes rose to record levels. From the NAR: “The median existing-home price for all housing types in June was $426,900, an all-time high and an increase of 4.1% from one year ago ($410,100). All four U.S. regions registered price gains.”
New home sales fall. Sales of newly built homes fell 0.6% in June to an annualized rate of 617,000 units.
Offices remain relatively empty. From Kastle Systems: “Occupancy Rises Across Cities After Weeks of Holiday and Weather Disruptions: The weekly average peak rose over five points to 61% on Tuesday this past week, as workers returned to the office in larger numbers after weeks of holiday and weather interruptions — especially throughout Texas. The weekly average low across all cities was Friday at 32.4% occupancy.:
Survey signals growth. From S&P Global’s July U.S. PMI: “The flash PMI data signal a ‘Goldilocks’ scenario at the start of the third quarter, with the economy growing at a robust pace while inflation moderates. Output across manufacturing and services is expanding at the strongest rate for over two years in July, the survey data indicative of GDP rising at an annualized rate of 2.5% after a 2.0% gain was signaled for the second quarter. The rate of increase of average prices charged for goods and services has meanwhile slowed further, dropping to a level consistent with the Fed’s 2% target.”
Keep in mind that during times of perceived stress, soft survey data tends to be more exaggerated than hard data.
Business investment activity is up. Orders for nondefense capital goods excluding aircraft — a.k.a. core capex or business investment — grew 1.0% to $73.99 billion in June.
Core capex orders are a leading indicator, meaning they foretell economic activity down the road. While the growth rate has leveled off a bit, they continue to signal economic strength in the months to come.
The economy grew nicely in Q2. According to preliminary Bureau of Economic Analysis data released on Thursday, U.S. GDP grew at an annual rate of 2.8% in Q2. This is up significantly from the 1.4% rate in Q1. Personal consumption grew at a healthy 2.3% rate.
Because the way GDP is calculated includes a lot of quirky metrics that distort the economic picture, economists will often point to “final sales to private domestic purchasers” to get a better sense of the underlying health of the economy. This metric excludes net exports, inventory adjustments, and government spending. That metric grew at a 2.6% rate in Q2, flat from the Q1 level.
Most U.S. states are still growing. From the Philly Fed’s June State Coincident Indexes report: “Over the past three months, the indexes increased in 40 states, decreased in eight states, and remained stable in two, for a three-month diffusion index of 64. Additionally, in the past month, the indexes increased in 35 states, decreased in 10 states, and remained stable in five, for a one-month diffusion index of 50.”
Near-term GDP growth estimates remain positive. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 2.8% rate in Q3.
Putting it all together
We continue to get evidence that we are experiencing a bullish “Goldilocks” soft landing scenario where inflation cools to manageable levels without the economy having to sink into recession.
This comes as the Federal Reserve continues to employ very tight monetary policy in its ongoing effort to get inflation under control. While it’s true that the Fed has taken a less hawkish tone in 2023 and 2024 than in 2022, and that most economists agree that the final interest rate hike of the cycle has either already happened, inflation still has to stay cool for a little while before the central bank is comfortable with price stability.
So we should expect the central bank to keep monetary policy tight, which means we should be prepared for relatively tight financial conditions (e.g., higher interest rates, tighter lending standards, and lower stock valuations) to linger. All this means monetary policy will be unfriendly to markets for the time being, and the risk the economy slips into a recession will be relatively elevated.
At the same time, we also know that stocks are discounting mechanisms — meaning that prices will have bottomed before the Fed signals a major dovish turn in monetary policy.
Also, it’s important to remember that while recession risks may be elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs, and those with jobs are getting raises.
Similarly, business finances are healthy as many corporations locked in low interest rates on their debt in recent years. Even as the threat of higher debt servicing costs looms, elevated profit margins give corporations room to absorb higher costs.
At this point, any downturn is unlikely to turn into economic calamity given that the financial health of consumers and businesses remains very strong.
And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have recently had some bumpy years, the long-run outlook for stocks remains positive.
