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FT editor Roula Khalaf picks her favorite stories in this week’s newsletter.
The writer is president of Queens’ College, Cambridge, and a consultant to Allianz and Gramercy
“It doesn’t matter when the Federal Reserve starts cutting rates.” It really depends on where they end up.” That’s the sentiment being heard on Wall Street.
On the face of it, the advice serves as an early warning to many market participants who are currently preoccupied with whether the Federal Reserve, reassured by the latest inflation data, will begin its rate-cutting cycle in September or wait longer, as several Fed officials have already suggested . week.
However, this view overlooks the importance of the timing of the first cut. Under current circumstances, timing is critical in determining the cumulative extent of the cycle and the well-being of the economy.
The usual argument for the importance of timing assumes that the first rate cut allows markets to price the full cycle of cuts with more certainty. This seems less important given today’s overly data-dependent Fed, which has refrained from taking a strategic view and, unfortunately, seems unlikely to change that approach anytime soon.
This lack of political anchoring has robbed fixed income markets of an important role. You see it in the behavior of US Treasury yields, whether it’s the policy-sensitive two-year bond or the 10-year bond, which captures more comprehensive market views of the entire rate cycle as well as inflation and growth outcomes.
Just four weeks before the Fed’s last meeting, the two-year yield fluctuated sharply: rising to nearly 5 percent, then falling 0.26 percentage points, rising 0.18 points and falling again 0.22 points to a low of 4.67 percent. The 10-year yield showed similar volatility, albeit with larger values.
A stronger argument for the importance of timing has to do with the state of the economy. Increasing, though not yet universal, data are signaling economic weakness, including worsening forward-looking indicators. This coincided with a significant erosion of the balance sheet reserves of small businesses and lower-income households. The vulnerabilities, which are likely to grow as further lagged effects of the 2022-23 major tourism cycle play out, come amid significant cyclical economic and political volatility, as well as changes in areas such as technology, sustainable energy, supply chain management and trade. .
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There is also a historical perspective that suggests that early rate cuts lead to better economic outcomes. As JPMorgan’s Bob Michele pointed out in an interview with Bloomberg Television last week, the rapid rate cut played a significant role in ensuring a “soft landing” after the 3 percent tourist cycle of 1994-95, a rare occurrence in history. This historical precedent should inspire a sense of optimism, suggesting that a well-timed rate cut could potentially lead to a similar positive outcome in the current economic environment (a soft landing probability I now estimate at 50 percent).
Given the dynamics of inflation, delaying the first rate cut makes it more likely that the Fed will eventually have to cut more to minimize the risk of a recession. This scenario would represent the opposite of the Fed’s original policy mistake in 2021-22. By mislabeling inflation at the time as “transitory” and delaying its policy response, the Fed had to aggressively raise rates by more than 5 percentage points, including four consecutive 0.75 percentage point hikes.
If the Fed were forced into a major tapering cycle this time due to a delayed start and accelerating economic and financial weaknesses, it would also have to end up tapering more than is necessary on longer-term terms. This follows a previous skirmish that exposed areas of financial vulnerability and, internationally, political challenges facing many other countries.
Again, vulnerable households and small businesses would be most exposed to this overshoot. The benefits of lower rates would be overshadowed by increased income insecurity or outright unemployment.
The final rate for the Fed’s upcoming rate-cutting cycle depends on when it starts, rather than a given one. The longer central bankers wait to taper, the more the economy risks unnecessary damage to its growth prospects and financial stability, hitting the more vulnerable segments particularly hard. In the process, the Fed would once again be stuck in a reactive policy response that is more of a gunfight than a strategic one, leading the economy to the soft landing that many of us hope for and the world desperately needs.