Has the Fed Waited Too Long to Cut Rates?

“The
lower
inflation
prints
we’ve
seen
over
the
past
couple
of
months
mean
the
Fed’s
predominant
concern
is
no
longer
inflation,”
explains
Roger
Hallam,
global
head
of
rates
at
Vanguard.
Rather,
he
says
the
focus
is
now
the
central
bank’s
dual
mandate
of
low
inflation and stable
employment.
The
longer
it
keeps
policy
rates
restrictive,
the
more
the
downside
risks
to
the
broader
economy
can
grow.

“They’re
always
weighing
the
trade-offs
of
the
dual
mandate,”
says
Ben
Bakkum,
senior
investment
strategist
at
Betterment.
Here’s
what
investors
need
to
know
about
the
fine
line
the
Fed
is
walking
and
the
risks
of
leaving
rates
too
high
for
too
long.

An
Historic
Tightening
Cycle

When
exactly
the
Fed
should
change
interest
rates
is
often
an
open
question.
The
impact
of
rate
changes
comes
with
a
long
and
variable
lag.
Meanwhile,
the
US
economy
has
proven
much
more
resilient
than
most
commentators
expected
amid
recent
massive
rate
increases.
Forecasts
that
a
recession
would
have
materialised
by
now
have
been
proven
wrong.

The
Fed’s
mandate
is
to
maintain
a
healthy
economy
by
keeping
inflation
low
and
stable
while
promoting
maximum
employment.
It
primarily
influences
the
economy
by
adjusting
the
federal
funds
rate,
which
is
the
rate
banks
use
when
they
lend
money
to
each
other
overnight.
Changes
in
that
rate
reverberate
throughout
the
entire
economy,
influencing
everything
from
longer-term
Treasury
yields
to
mortgage
rates,
credit
card
rates,
and
corporate
profits.

Fed
officials
spent
a
significant
portion
of
2021
describing
the
elevated
price
pressures
that
followed
the
pandemic
as
“transitory” –
not
ideal,
but
temporary.
But
when
those
pressures
didn’t
fade
and
the
inflation
rate
climbed
to
a
40-year
high,
they
shifted
gears
quickly.
“The
Fed
did
a
pretty
decent
job
from
that
point,”
Hallam
says.

“It
moved
policy
to
a
tight
stance
and
has
been
maintaining
this
stance
to
bring
the
economy
into
better
balance.”

The
Fed’s
Balancing
Act

For
the
most
part,
the
high
rates
have
successfully
slowed
the
economy
and
reduced
inflation
from
its
peak
of
about
9%
to
3%
in
June –
a
recovery
that
is
“quite
remarkable,”
according
to
Nationwide
chief
economist
Kathy
Bostjancic.

With
job
growth
moderating
along
with
inflation,
central
bankers
face
a
more
complex
balancing
act.
Given
all
the
progress
on
inflation,
Hallam
says
the
Fed
is
“very
conscious”
of
downside
risks.

“We
have
to
keep
both
mandates
in
our
mind,”
San
Francisco
Fed
President
Mary
Daly said
last
week.
“It’s
a
risk
to
act
too
soon
to
normalise
interest
rates
and
then
have
inflation
stuck
above
our
target,
and
it’s
a
risk
to
hold
on
too
long
and
make
the
labour
market
falter.”

The
Case
for
a
July
Rate
Cut

While
the
markets
don’t
see
much
chance
of
a
cut
before
September,
the
question
of
whether
that
would
be
too
late
is
“definitely
apropos,”
says
Bostjancic.
A
larger-than-expected
moderation
in
the
labour
market
that
begins
to
dent
consumer
spending
“could
suggest
that
they
waited
too
long.”

Analysts
at
Goldman
Sachs
are
also
expecting
a
September
cut,
but
they
recently
laid
out
a
case
for
why
a
July
cut
wouldn’t
be
a
bad
idea.
They
point
out
that
the
case
for
a
rate
is
already
clear,
given
how
much
inflation
has
fallen
and
how
the
labour
market
has
come
into
balance.
“Why
wait
another
seven
weeks
before
delivering
it?”
they
asked
in
a
research
note
to
clients
last
week.

And
given
that
monthly
inflation
data
can
be
volatile,
Goldman
Sachs
analysts
say
there’s
a
risk
of
a
temporary
reacceleration
in
inflation
over
the
coming
months,
which
would
make
a
September
cut
look
like
a
policy
error.
“Starting
in
July
would
sidestep
that
risk,”
they
wrote.
Lastly,
they
point
out
that
the
Fed
has
an
unspoken
incentive
to
avoid
major
policy
moves
too
close
to
elections.
“That
doesn’t
mean
the
committee
couldn’t
cut
in
September,”
the
analysts
wrote,
“but
it
does
mean
that
July
would
be
preferable.”

The
Case
for
Waiting

Bostjancic
acknowledges
that
the
central
bank’s
cautious
stance
is
understandable,
especially
given
three
months
of
hotter-than-expected
CPI
readings
at
the
start
of
the
year.
“The
worst
outcome
is
if
they
don’t
slay
inflation,”
she
says.

For
Hallam,
a
moderating
economy
isn’t
necessarily
a
sign
that
the
Fed
has
waited
too
long
to
begin
easing.
“The
economy
is
still
humming
along,”
he
says,
and
GDP
remains
near
its
longer-term
trend.
“The
labour
market
has
been
slowing,”
but
it’s
“not
necessarily
slow.”

A
stronger-than-expected
second-quarter
GDP
report
also
supports
the
Fed
can
“remain
patient,”
Bank
of
America
analysts
wrote
Thursday.
“Growth
has
certainly
cooled
relative
to
last
year,
but
it
has
done
so
at
a
gradual
pace
[…].
The
risk
of
a
sharp
slowdown
is
low,
in
our
view.”
Bank
of
America
expects
the
first
rate
cut
to
come
in
December.

Lagged
Effects
of
Fed
Policy

Complicating
the
picture
is
that
changes
in
Fed
policy
affect
the
economy
slowly,
with
occasionally
unpredictable
side
effects.

“Restrictive
policy
from
the
Fed
doesn’t
impact
the
market
immediately,”
says
Matt
Rowe,
head
of
portfolio
management
and
cross-asset
strategies
at
Nomura
Capital
Management.

While
policy
changes
impact
the
short
end
of
the
yield
curve
relatively
quickly,
it
takes
more
time
for
them
to
work
their
way
through
to
the
long
end
of
the
curve
and
the
rest
of
the
economy.
That
means
there
could
still
be
effects
of
high
rates
that
have
yet
to
work
their
way
into
economic
data,
or
all
the
impact
of
the
Fed’s
tightening
cycle
could
have
already
been
felt.

Bakkum
points
out
that,
over
the
last
few
years,
higher
rates
have
had
an
unexpectedly
small
effect
on
the
economy.
“That’s
the
surprise,
how
much
the
economy
has
been
resilient
to
the
tightening,”
he
says.

Rowe
adds
that
there
are
elements
of
inflation
and
the
economy
that
the
Fed
can’t
control.
It
could
cut
rates
but
home
prices
could
keep
rising,
for
instance,
which
would
be
a
major
setback
in
the
inflation
fight.
Rising
insurance
costs
also
pose
an
inflation
risk.
He
thinks
these
lagged
effects
mean
the
central
bank’s
“wait
and
see”
strategy
makes
sense.

“It’s
reasonable,
in
my
opinion,
that
the
Fed
has
waited
and
tried
to
be
patient,”
he
says.

When
Will
the
Fed
Cut
Rates?

Investors
still
see
commanding
odds
that
interest
rate
cuts
will
begin
in
September.
Bond
futures
markets
currently
price
in
a
nearly
90%
chance
of
a
0.25%
reduction
happening
at
the
central
bank’s
meeting
that
month,
according
to
the
CME
FedWatch
Tool.
The
current
federal
funds
rate
target
range
is
5.50%-5.25%,
and
traders
see
a
59%
chance
that
it
will
be
4.50%-4.75%
after
the
Fed’s
December
meeting.

“The
Fed
is
optimistic
that
cuts
are
likely
in
the
near
term,
but
we
do
not
think
it
is
willing
to
signal
September
is
a
done
deal,”
Bank
of
America
analysts
wrote.
Over
the
past
few
weeks,
Fed
officials
have
emphasised
that
they
have
not
yet
gained
the
confidence
they
need
to
ease
policy.

Bakkum
says
that
if
the
downside
risks
of
prolonged
tight
policy
emerge,
investors
should
prepare
for
some
short-term
volatility
in
financial
markets
as
economic
growth
slows.
But
over
the
long
term,
“it’s
not
worth
timing
that
kind
of
thing.”
He
recommends
that
investors
with
long-term
horizons
stick
to
their
diversified
investment
plans
rather
than
risk
missing
out
on
the
potential
for
stocks
to
keep
rising.

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