Traders Wants A Rate Cut; They Should Be Careful What They Wish For

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We will hear today the results of the Fed's deliberations at their monthly meeting. There is always some speculation as to what that will bring, particularly at the quarterly meetings that are followed by a press conference, but this time is a little different. While it is generally viewed as unlikely that rates will be changed this afternoon, there is a strong consensus view that there will be significant changes to the language of the statement, indicating a rate cut following one or both the next two meetings.

That is not that unusual, but the circumstances that have led to that view are.

From the perspective of the data that are supposed to drive these things, there is no need to cut rates. There is no recession nor looming crisis here. Unemployment is low and stable. Growth is decent if not spectacular, pushing corporate profits ever higher in a way that looks more sustainable than frothy.

There are some signs that the rate of growth is beginning to slow, but after a decade of expansion that is neither unexpected nor a bad thing in terms of sustainability.

So, why is a cut being even considered?

The answer, as is often the case with economic decisions that make little economic sense, is politics.

Donald Trump has been putting pressure on Fed Chair Jerome Powell to cut rates. He is not the first President to be unhappy with the actions of the Fed, nor will he be the last, but when it comes to how the central bank operates that is a feature, not a bug. The Fed is charged with making decisions that are for the good of the long-term economic health of the country, even if those decisions have negative short-term political effect.

That is why, by law and tradition, the Fed chair is independent.

The pressure this month has risen to the point where questions are openly being asked as to whether Powell will be replaced if he doesn’t ensure a rate cut this time. Under other recent Presidents that is not a question that would have been considered, but Trump has demonstrated that conventions and norms just aren’t his thing, and that he is quite prepared to fire anybody who he sees as crossing him.

To be fair, Trump is not the only one calling for a rate cut. The market has been doing so too, both in public commentary by many players and in its reactions to various news on the subject. While that is in some ways more noteworthy as it is about more than just politics, traders would be advised to temper their enthusiasm should they get what they want today.

Obviously, lower rates are good for stocks. They would increase the disparity between the return on bonds and what can be expected from stocks based on historical averages, and that pushes even more money into the market. They also encourage more borrowing and investment, and that would stimulate growth.

The problem, however, is that if the precedent is set that the Fed’s policies are subject to the short-term needs of politicians, there will be a reaction.

The U.S. stock market is the most attractive place for global capital for several reasons, but not least among them is that it is relatively free of political interference. Given the desire, some would say even the duty of politicians to regulate, there is no such thing as a truly “free” market in the modern world, but America is about as close as it gets.

If that status is threatened, as looks possible today, the reaction won’t be immediate, but it will come. Initially, traders would celebrate the things mentioned and a quick jump in stocks would follow such a decision. Over time though, longer-term investors would start to foresee a future when politicians of a different stripe feel licensed to control monetary policy. They will imagine a Fed, and therefore a market, under the control of a Bernie Sanders or Elizabeth Warren, and at the very least that will temper their enthusiasm somewhat.

It is not that those two people, nor anyone else including Donald Trump for that matter, would believe that their actions were not in America’s best interests, but that isn’t the point. Once the independence of the central bank is removed, monetary policy joins fiscal policy in being in the control of politicians, and we saw in the aftermath of the Great Recession how important the separation is.

History suggests that fiscal policy at that time was, based on political consideration, too tight to stimulate a reeling economy. The Fed’s easy monetary policy was needed to counter that. You don’t have to try too hard to imagine what would have happened without that; you have only to look at Europe. Both fiscal and monetary policy remained tight there for a few years after the collapse, and their recovery was delayed until that changed.

If the separation of the two arms of economic policy is challenged later today, similar problems in America become much more likely at some point in the future. Investors will see almost certainly see the danger in that once the initial euphoria fades.

There is an old saying that you should be careful what you wish for as you might just get it, and that seems to apply to the stock market today. Hints of a rate cut would be good initially, but would set us up for much bigger problems to come.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: News Headlines , Central Bank , Economy , Stocks , US Markets

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