Would an Interest Rate Cut be Wise?

Posted on Monday, July 15th, 2019 Chris Markoch

You can’t listen to the financial news without hearing one expert or another offering their opinion on the Federal Reserve’s potential rate cut at the end of this month. In June, Fed Chairman Jerome Powell said the Fed needed more information before taking a more accommodative stance on interest rates. However, in his testimony to Congress in July, Chairman Powell stated that the U.S. economy had not shown improvement since the last Fed meeting. The market surged as analysts saw the Chairman's remarks as confirmation that the Fed will lower interest rates by 25 basis points at their July meeting. 

Even if the Fed does not cut interest rates in July, almost half of the 17 Fed officials who decide on interest rate policy have signaled their support for at least one rate cut before the end of the year.

It’s creating interesting questions for investors who are looking at where to invest for the remainder of the year. Is a lower interest rate vital to the U.S. economy, or would such a boost provide a beneficial, but the unnecessary stimulus that will leave the Fed with one less lever to pull in the event of a recession?

Both stocks and bonds can't be right

One argument for lowering interest rates is that it would clarify the market’s direction. Typically stocks and bonds move in (relatively) opposite directions. However, currently, both stocks and bonds have been rising, which is creating mixed signals. A cut in interest rates would undoubtedly give a boost to equities and, by some accounts, create clarity for investors as to the overall market direction.

The markets fear a lack of global growth

Another argument for lowering interest rates is that while the U.S. economy is still showing some strength, the global economy is not. The European Central Bank (ECB) and the Central Bank of Japan continue to have negative interest rates that have yet to give their respective economies the boost that they need. There are even some rumblings that foreign central banks may take the unprecedented action of buying equities. A weak European economy is having a spillover effect on many U.S. multinational companies who continue to see weakness in their overseas divisions. Against this backdrop, a cut in interest rates would help ensure these companies have the necessary liquidity to manage through these times.

China remains an important unanswered question. The Chinese economy recently reported slower growth of 6.2%, down from 6.4% in the first quarter of 2019 and 6.6% for all of 2018. It’s the slowest growth rate for China in almost 30 years. Most of the downturn was attributable to the current tariff dispute with the United States.

The United States is a tale of two economies

Another argument for lowering interest rates is that the United States economy is telling two different stories. There is still a large segment of the U.S. economy that is not benefiting from the bull market. Wages remain stubbornly low at the lower end and many Americans place job security as one of their primary concerns. Although this concern is not being reflected in consumer confidence figures right now, many analysts are hoping that an interest rate cut will spark lending to prevent a decline in consumer confidence – which makes up a high percentage of economic growth. 

On the other hand, there are cases against raising interest rates.

The Fed is hitting its target...for now

The Federal Reserve’s mandate is to achieve and maintain stable prices and maximum employment. Currently, the economy has been staying at or below the Fed’s targets in both areas. In fact, both numbers may be lower than the Fed would like. But, the global economy means that the Fed’s interest rate policies have less effect on interest rates than it did forty years ago. Prices of many goods and services rise or fall for reasons that have nothing to do with the Fed.

Markets are forward-looking, economic data is not

One of the reasons why some economists suggest the Fed should hold the line on interest rates is that the data they are looking at does not always reflect what is happening in the market at the moment. For example, a recent survey by Allianz Life showed that over 50% of those surveyed were very concerned that the U.S. economy was headed for a recession, and they were actively looking for strategies to manage risk. The survey, however, was conducted in May which was the worst month of 2019 for the S&P 500. But the index, along with other stock market indexes, recovered in June and as recently as June 13 closed at an all-time high of above 3,000. This is the inherent problem with much of the economic data that the Fed receives. Many are based on events that have already happened but do not take into account – or stand in conflict with – what is occurring in the economy at this time. 

The Fed can telegraph their punches

Rather than cutting interest rates now, the Fed can commit to a clear, and very accommodative, monetary policy if, for instance, the unemployment rises to 4.1 percent (one-half percent above its current level) and hold it there until the unemployment rate goes below that level. This would give businesses and consumers the confidence to spend today with the assurance that the Fed will lower rates should recessionary forces come into play.

In the end, elections affect economic policy

James Carville, a political strategist for President Clinton's successful 1992 Presidential campaign famously quipped, "It's the economy, stupid". As we head into an election year, it's useful to remember this statement as politicians are desperate to avoid having the economy teeter into a recession prior to the election. Throughout 2019, the Trump administration has been lobbying the Fed to reduce interest rates. While the Fed is supposed to be apolitical, it's a fair question to ask how much longer the Fed will continue to ignore the political pressure to lower rates.

 

 

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