Independent From Whom?

Fed Chairman Jeremy Powell is not an academic economist, but he’s learnt to think like one: his economic analysis starts from the desired conclusion and works backwards to build the necessary supporting arguments.

At its June policy meeting, the Fed expressed concern about global trade tensions and the outlook for growth. Powell said the Fed would look at the new data coming in, and might reduce interest rates as insurance against uncertainty. Financial markets promptly moved to expect 75 basis point in rate cuts in the remainder of the year, starting this month.

Uncertainty has increased, we need to be cautious, said the Fed. Investors nodded in agreement and rushed to take on more risk: the S&P500 stock index had its best June performance since 1955 (this is not a typo) and the best first half of the year since 1997; the Dow had the best first half since 1999.

Then trade talks at the G20 Summit in Japan proved constructive, and employment data rose well beyond expectations. Stock markets fell on the news. That’s right, stock prices fell because the economy is doing better than expected. Then today, once Powell reassured investors that the economic outlook has not improved at all, stock prices surged to new highs. Maybe — just maybe — equity markets have developed an unhealthy dependence on easy money?

The Fed seems scared of disappointing equity markets, so Powell feels he must cut rates later this month. Therefore, in his Testimony in Congress this morning he argued that the economic outlook has not improved since the last meeting. The easing of trade tensions and the strong jobs numbers get brushed aside, because they don’t fit the story. That’s how many academic papers in economics get written.

The doves on the Fed argue that if sagging business sentiment starts to undermine economic activity, they need to cut rates before that weakness shows up in the data. That’s a reasonable argument, but I have two objections: (1) monetary policy is already very loose: the policy rate is just above current inflation, and inflation expectations are higher and rising, according to the latest New York Fed survey which pins 1-year ahead expected inflation at 2.7% — on this basis the real policy interest rate is negative; (2) surging equity prices have made financial conditions easier. The Fed has already bought insurance against uncertainty by adopting an extremely slow and cautious pace of policy normalization.

The natural counter to my objections is since inflation is low, what’s the harm in cutting rates?

Well, there is no free lunch — and no free insurance. If uncertainty is dangerously elevated and yet asset prices are sky-high and rising, then financial markets are at the very least frothy. Loosening monetary policy further will exacerbate financial dislocations. Maybe nothing bad will happen — but we’re taking a risk. We should acknowledge it and weigh it against the risk of weaker economic growth, not pretend we’re getting insurance for free.

A related downside is the Fed’s loss of independence — not to politics, but to markets. Financial markets, and equity markets in particular, will want rates lower and lower. The Fed is backing itself into a corner: it validates market pressures, and then feels it cannot disappoint investors for fear that equity prices will fall. That’s a dangerous trap.

Equity investors clamor for rate cuts while pushing stocks to all-time highs; if the Fed allows them to dictate policy, there is no guarantee they will guide rates to the right level.

The Fed will cut rates later this month. But as it does, it should push back against investors and start guiding market expectations, rather than be guided by them.