The Fed needs to cut rates as quickly as possible

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Roula Khalaf, editor of the FT, selects her favorite stories in this weekly newsletter.

The writer is president of Queens’ College, Cambridge, and advisor to Allianz and Gramercy

“It doesn’t matter when the Federal Reserve starts cutting rates. The most important thing is where they end up.” That’s a position being heard on Wall Street.

At first glance, this advice serves as a timely warning to the many market participants currently obsessed with whether the Federal Reserve, reassured by the latest inflation data, will begin its rate-cutting cycle in September or wait even longer, as several Fed officials suggested last year. week.

However, this view ignores the importance of the timing of the first cut. In current circumstances, timing is crucial in determining the cumulative size of the cycle and the well-being of the economy.

The usual argument for the importance of timing is that the first rate cut allows markets to estimate the entire rate cut cycle with more confidence. This seems less important given the current overly data-reliant Fed, which has refrained from taking a strategic view and unfortunately seems unlikely to change this approach anytime soon.

This lack of policy anchoring has robbed fixed income markets of an important direction. You see this in the behavior of US Treasury yields, whether it’s the policy-sensitive 2-year bond, or the 10-year bond that reflects more comprehensive market views of the entire interest rate cycle, as well as inflation and growth outcomes.

In the four weeks before the Fed’s last policy meeting alone, the two-year yield fluctuated significantly, rising to nearly 5 percent, then falling by 0.26 percentage points, rising by 0.18 points, and falling again by 0.22 points to a low of 4.67 percentage points. per cent. The 10-year yield showed similar volatility, albeit with greater magnitude.

The stronger argument for the importance of timing has to do with the state of the economy. The increasing, although not yet universal, numbers point to an economic weakening, including worsening forward-looking indicators. This coincided with a significant erosion of the balance sheet buffers of small businesses and lower-income households. The vulnerabilities, which are likely to increase as more of the delayed effects of the 2022-2023 great hike cycle materialize, arise from significant cyclical economic and political volatility, as well as transitions in areas such as technology, renewable energy, supply chain management and trade. .

There is also a historical perspective that suggests that a timely interest rate cut contributes to better economic outcomes. As JPMorgan’s Bob Michele highlighted in a Bloomberg Television interview last week, a rapid rate cut played an important role in achieving a “soft landing” after the 3 percentage point rate hike cycle of 1994-95, a rare event in history. This historical precedent should create a sense of optimism, suggesting that a well-timed rate cut could potentially lead to a similarly positive outcome in the current economic landscape (a soft landing chance I now estimate at 50 percent).

Given inflation dynamics, pushing back on the first rate cut increases the likelihood that the Fed will eventually have to cut even more to minimize the risk of a recession. This scenario would be the reverse of the Fed’s initial policy error for 2021-2022. By incorrectly labeling inflation as “transitory” at the time and delaying its policy response, the Fed had to aggressively raise rates by more than 5 percentage points, including four consecutive increases of 0.75 percentage points.

If the Fed is forced into a major austerity cycle this time due to a delayed start and increasing economic and financial weakness, it could also end up having to cut more than is necessary based on longer-term conditions. This follows the previous upward overshoot that exposed the financial fragility and, internationally, the policy challenges faced by many other countries.

Once again, vulnerable households and small businesses would be most exposed to such an excess. The benefits of lower rates would be overshadowed by greater income insecurity or outright unemployment.

The final interest rate for the upcoming Fed rate cutting cycle is not fixed, but depends on when it starts. The longer central bankers wait to make cuts, the greater the risk to the economy of causing unnecessary damage to growth prospects and financial stability, hitting the more vulnerable segments particularly hard. In doing so, the Fed would once again be stuck with a reactive policy response of firefights instead of a more strategic response that guides the economy toward the soft landing that many of us hope for and that the world desperately needs.