Financial Planning & Wealth Management

Fed Rate Cuts: Ask Why, not When

The latest consensus regarding when the Fed will begin cutting rates, and consequently when central banks worldwide will follow suit, is the second half of this year.

 

Reflecting on the past year, with inflation steadily declining, the consensus initially suggested rate cuts at the start of this year. However, that anticipation hasn’t materialized. The rate cut view hasn’t changed, it has just been pushed out. 

 

“Higher for longer” has been the prevailing theme in investment discussions over the past few months.

 

Take a look at the US inflation chart below – you’ll notice it appears to be plateauing around the 3.5% mark. Given that the Fed targets 2% inflation, the notion of maintaining higher rates for an extended period seems logical.

 

Chart: US Inflation rate

I hold a different perspective on this view and believe we’re asking the wrong question. Rather than speculating about when the Fed will cut rates, we should be asking why such a move would be necessary or what circumstances would warrant it.

 

Currently, the US unemployment rate is at record lows, the economy is thriving, wages are at historic highs, and consumers are cash flush. I’ve written about this here

 

The crux of the matter is that there’s no compelling reason for the Fed to reduce rates. With rates relatively high, the Fed maintains surplus ammunition in the form of potential rate cuts to address any future market or economic crises.

 

Given these conditions, and assuming minimal change, I don’t see why the Fed would feel compelled to cut rates at all.

 

So, under what conditions might the Fed lower rates? I see two potential scenarios:

 

a) A significant economic slowdown occurs, leading to a skyrocketing unemployment rate. In this scenario, the Fed would intervene with rate cuts to alleviate consumer distress.

 

In this scenario, the equity markets would correct, and bond investments would do very well

 

b) Inflation recedes to the target 2%, prompting the Fed to declare victory. Similar to an athlete winning a race after rigorous training, the Fed’s “victory lap” would be the rate cut. However, in this scenario, the rate cut would likely be minimal.

 

What does historical data say about the factors influencing Fed rate cuts? The chart below illustrates the history of Fed fund rates since the early 90s. 

 

Chart: History of the Fed fund rates

I’ve highlighted four periods of rate cuts. In the first instance, the Fed celebrated its success as inflation reached record lows, resulting in only marginal rate reductions. Consequently, the markets soared to new heights.

 

However, in every subsequent case (2 – 4), the Fed implemented rate cuts in response to a market crises. The second period coincided with the dot-com bubble, the third with the Global Financial Crisis, and the fourth with the Covid crash.

 

I’d conclude from this that only a market crash would necessitate rate cuts to levels seen pre-covid (1% to 2%). 

 

When the economy and labor market are robust, the likelihood of a rate cut diminishes significantly. Why bother cutting rates when there is nothing wrong with the economy.  

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 MattFin is a blog that focuses on wealth management, investments, financial markets and investor psychology. I build financial plans and portfolios for families and individuals

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