By Dr. George Calhoun
Hanlon Investment Management Advisory Board Member
Executive Director of the Hanlon Financial Systems Center
On September 18, at precisely 2:00 pm, the Chairman of the Federal Reserve announced a reduction of 50 basis points (½ of 1%) in the Fed Funds target rate.
It was the first rate cut in 4 ½ years, finally reversing the most aggressive interest rate increase program in decades.
50 bps was said to be “emphatic.” The Financial Times called it a “jumbo cut.” The Wall Street Journal headlined “Fed Goes Big.”
The End of Higher For Longer Chart by author
This speed and severity of this policy may not have had much effect on inflation, but it has inflicted significant collateral damage on several sectors of the economy. In my previous column, I examined the impact of the rate storm on the housing market. Here the focus is on another multi-trillion dollar segment of the financial system, where rising rates may be distorting the market and creating new systemic risks: Money Market Funds.
Chairman Powell called it “an appropriate recalibration” – and repeated that phrase nine times.
The announcement set the stock market ringing like a bell.
The Dow Jones Industrial Average for Sept 18, 2024 Chart by author
The Dow Jones Industrial Average jumped 300 points in the first 60 seconds after Powell began to speak. Then it fell back 300 points. Then it was up 200. And then down 280. Up again, and then down 400. In 2 hours, the supposedly staid Dow racked up almost 2500 points in round trip mileage – trillions of dollars of value sloshing around in the gold-plated bathtub known as the U.S. stock market.
The next day, turmoil gave way to relief. The market surged to a new record. “A furious rally” swept global markets. European stocks had their best day in a month. Japan’s Nikkei average was up 2%. The announcement pushed all the other big stories of the day – the Presidential race, Gaza, Ukraine – to the sidelines.
A Chick-Fil-A sign in northeast Washington DC alerted customers to the big news: “50 points.” A strange message from a fast food outlet. Was an update on monetary policy somehow more important than the price of a chicken sandwich? Or maybe it was a clever prompt – Come on in, let’s celebrate!
Big, bold, jumbo, emphatic, furious, all that – however, this move was no surprise. It would be hard to even call it “news.” Chairman Powell all but pre-announced the rate cut 27 days prior to the event – “the time has come for policy to adjust” – in his Jackson Hole address. The timing was known. The direction was known. The markets had ample opportunity to price it in. A believer in efficient markets would have said that very little new information was introduced on Wednesday.
(True, the exact size of the rate cut was not known. 25 basis points? or 50? It had become the focus of intense speculation. But does this small difference really matter? Not everyone thinks so. I’ll come back to it below.)
The ragged price discovery path on Sept 18 exposed the clash of two opposing “investment theses,” battling it out in the market.
On the one hand, monetary easing usually bodes well for the stock market. Since 1974, on occasions where the Fed initiated a rate cutting cycle, the market has been up eight out of ten times the following year.
S&P 500 Performance After Fed Funds Rate Cuts Chart by author
On the other hand, the last three rate cutting episodes have been less fortunate for investors. In those cases, the cut was followed by an economic downturn. If the economy today really needs a stimulus, maybe it means there’s trouble ahead. According to Torsten Sløk of Apollo, the rates markets are already pricing in a recession. The Wall Street Journal was spooked in particular by the size of the reduction.
- “A half point cut is a big cut. If there’s not some kind of emergency happening in the economy or in the financial markets, the Fed really prefers to move in quarter-point increments.” – (Sept 19, 2024)
Still, on Thursday morning the Dow opened up 450 points, and maintained this level for several days now. The optimists’ view has prevailed, for now.
But is this optimism justified? In all this sound and fury, what is the real news here? There are several layers of misinterpretation that have to be stripped away to get at the true significance of this event.
What Does The Rate Cut Really Mean?
An adjustment of the Fed Funds Rate can be interpreted in two ways:
- As a policy measure that will have an impact on the real economy, presumably by modulating the cost of credit, and through that channel, affecting business investment and consumer demand, and/or
- As messaging, intended to shape the psychology of the markets, the American public, and the world
Implications for the Real Economy?
Some assume that lowering the Federal Funds Rate will have a direct positive effect on the economy, reducing the cost of credit, stimulating demand and spending, influencing banks’ lending, even boosting the labor market and creating new jobs. But is this likely?
It is not clear.
First of all, what is the Fed Funds Rate (FFR), exactly? The way it’s talked and written about, one might think the Fed is immediately mandating lower interest rates across the economy. But no – the FFR applies only to the interest rate target for overnight loans of a very specific type, involving transactions between banks.
The FFR comes into play when a bank finds itself with more cash on account with the Fed (its reserves) than it really needs – or not enough. If Bank A is short and wants to top off its reserves, it can borrow from Bank B which has a surplus – and Bank B can earn some interest. The actual FFR (different from the target FFR) is the interest rate that Banks A and B freely negotiate for this transaction. It is determined by the banks, not by the Fed.
That’s a key point. The Fed doesn’t actually set the rate; it only defines a target. Whether the FFR target has any effect on the credit markets depends on whether the banks go along.
- “Although this is commonly referred to as ‘setting interest rates,’ the effect is not immediate and depends on the banks’ response to money market conditions.” – Wikipedia
The Fed is merely an “influencer” – albeit a powerful one, with various carrots and sticks to deploy for encouraging the private sector to play along.
[Note: The mechanisms for controlling the market’s response to the FFR and reserve levels are quite complicated, involving other interest rates which the Fed can set and are not simply targets. Still, the system is not fully deterministic, and depends substantially on market responses from private sector participants (banks).]
So what is the effect of the Fed dropping the target by ½ of 1%? As noted, that ultimately depends on what the banks do, driven by market conditions and the real demand for credit. Actual market rates for interbank credit transactions that impact the economy are often significantly higher than the FFR target. The interbank offered rate – which was for decades the chief measure of the cost of credit in the market – is almost always higher than the FFR (partly due to the longer term, of course, but also partly due to the difference between “market reality” and “policy goals”).
Libor vs Fed Funds Rate Chart by author
The shifts in the market rate also tend to lag the reversals in the central bank policy by several quarters.
- “The Fed easing rates yesterday really doesn’t affect the economy today… It will help the economy in the future, but over the next four to six months, the economy is still going to feel the lagged effects of tightening.” – An analyst cited in the Wall Street Journal (Sept 23, 2024)
It is hard to make the case that shaving a few basis points off the target for an overnight funding benchmark that only applies to banks lending to each other (not to consumers or businesses) would per se have an immediate impact on the real economy. The causal link is too attenuated, and the size of the adjustment is too small, to move the needle in a $100 Trillion credit market. For comparison, consider that the interest rate on 30-year home mortgages has fallen by over 100 basis points since May, and home sales have continued to decline, dropping by 12% in that period. Cheaper credit does not necessarily spur more borrowing.
But it is assumed – typically without question – that the reduction in the FFR will at least lead to a lowering of other interest rates. In fact, the rates (yields) on Treasurys actually rose after the announcement of the Fed Rate cut, as The Wall Street Journal reported:
- “Yields on longer-term U.S. Treasurys have ticked higher since the Fed approved a 0.5 percentage point rate-cut last week. The yield on the benchmark 10-year U.S. Treasury note, which helps set interest rates on everything from mortgages to corporate bonds, settled Friday at around 3.73%, up from 3.64% the day before the Fed’s move. The climb is a reminder that the Fed doesn’t have complete control over borrowing costs in the country.” [Emphasis added]
Treasury Yields arguably influence credit markets much more than the FFR.
- “The central bank manages short-term rates that banks charge each other for overnight loans… But rates on a lot more debt are driven primarily by swings in Treasury yields. Those are set by where investors think the Fed’s short-term rates will go in the future, rather than where they are now.” – (September 23, 2024)
Over time, trends in short term rates like the FFR and in longer-term rates like 10-year Treasury yields do tend to align, but the relationship is quite noisy. It is neither automatic nor necessarily immediate. This suggests that the causal connection is not as solid as is usually supposed.
Interest Rate Policy as Messaging
Fed rate policy is better understood as a messaging program. The FFR is a crucial signal. But what is it signaling?
The view of many economists and financial market analysts is that the current rate cut, relatively insignificant in itself, predicts the future trend in rate cuts which will eventually cumulate to produce a more substantial impact.
- “A quarter-point difference to a single short-term interest rate is, in isolation, of little significance to the wider economy. What matters about the size of a particular cut at a particular time is what it signals about the central bank’s extended journey: where it thinks rates need to be, and when it thinks it needs to get there.” The Financial Times (Sept 20, 2024)
Some observers, including some at the Fed itself, now forecast rates reaching 3% by the end of 2026. The Federal Open Market Committee’s dot plots project another ~200 bps reduction over the next two years. (Of course it must be acknowledged that the Fed is “terrible at predicting what it will do.”)
FOMC Forecasts of the Fed Funds Target Chart by author
It is an article of faith that changes in the FFR impact credit costs across the economy. This affects the real economy in certain ways. Changes in the growth rate of consumer loans are inversely correlated with the FFR after a lag of about 6 months – meaning lower rates will stimulate borrowing. But more fundamental measures of economic health – GDP growth, consumer spending, job creation – do not show the same pattern.
- Since 1984 the correlation of the FFR with the GDP growth rate one year later is only 13%, and two years later the correlation is only 4%. Essentially zero.
- The correlation with consumer spending growth rate two years later is just 14%.
- The correlation with unemployment is -18%.
- Over the last ten years, the FFR has essentially zero correlation (-2% to -7%) with jobs growth 3, 6, 12 and 24 months later.
For those unfamiliar with the meaning of correlation statistics, all of these readings signal a very weak association, if any. Correlation doesn’t prove causality, but lack of correlation is strong evidence for the absence of causality.
The lack of correlation with jobs growth is particularly striking, since Fed officials have explicitly tied the rate-change decision to the health of the labor market. Yet the FFR apparently has had no measurable effect on job creation over the last decade.
Correlation of the Fed Funds Rate With Lagged Job Growth (2014-2024) Chart by author
The FFR appears to be ineffectual with respect to impacting many measures of real economic performance in the following 1-2 years.
Is The Rate Cut Really About Protecting The Fed’s Reputation?
So, was the Fed’s announcement, or the media’s headline interpretation of it, “fake news”?
Much of the coverage is misleading at least. The reduction in interest rates will not cure whatever ails the labor markets. Based on past experience, it will not directly spur job creation or economic growth, either immediately or over the next couple years.
The real message of this maneuver is quite different. It is has to do with public psychology, and public trust, which Jerome Powell as has said “is really the Fed’s and any central bank’s most important asset.”
The Federal Reserve is a faith-based institution. Its effectiveness rests on the public confidence.
- “A loss of credibility directly affects [the Fed’s] ability to maintain financial stability and guide markets.” – Mohammed El-Erian (April 2023)
The surge of inflation in 2021-2022 (which trailed through the year-over-year statistics well into 2023) damaged the Fed’s credibility enormously. In December 2022, the Washington Post wrote in a lead editorial:
- “The Federal Reserve’s greatest resource is its credibility. People have to believe the central bank will get inflation under control — or else inflationary psychology becomes entrenched and causes years of pain. Likewise, people need to trust that Fed leaders will prioritize what’s best for the nation over any personal gain — otherwise the central bank won’t survive.” [Emphasis added]
This is strong language. But the danger is real. Confidence in the Fed touched an all-time low in 2023, and is up only slightly in 2024. The Fed’s “most important asset” has been dangerously impaired.
Public Confidence in the Fed is at an All-Time Low Chart by author
The rate cut was really about repairing the Fed’s credibility. “Going big” with 50 basis points is not about the economic impact. It is a psychological gambit, intended to convey decisiveness and self-confidence.
FEBRUARY 1, 2023: Fed Chair Jerome Powell Talking about Inflation, Watching the Video on CNBC Television YouTube Channel, on a MacBook Pro
Powell used that interesting new word – “recalibrating” – nine times in the press conference. It is the next policy mantra, replacing “transitory” and “higher for longer” etc. “Recalibration” suggests that monetary policy is a machine that is capable of precision and accuracy. The Fed needs the public to believe that it can fine-tune policy and control events once again.
This is misleading, however, if not outright deception (“fake news”?). When it comes to the real economy, the Federal Reserve is ineffectual, even helpless, to a degree far greater than it can afford to admit openly. The Central Bank neither caused nor cured the recent surge of price inflation. It can do nothing to affect the price of gasoline or eggs or used cars. It cannot “create jobs.” It can barely influence the cost of bank credit. It can’t even do very much to help the housing market, which is the sector of the economy where interest rates matter most. “The Fed can cut rates but it can’t fix the housing crisis” headlined Fortune magazine (Sept 19, 2024).
- “All of the aspects of housing are far more difficult, and where are we going to get the supply? And this is not something the Fed can really fix.” – Jerome Powell (Sept 18, 2024)
The Fed is the Central Bank not just for the United States, but in effect for the entire world – and the world needs a Central Bank it can believe in. Credibility is crucial and the Fed is right to do what it can to try to recover it. But we should understand what the rate cut was really about. It should not be advertised as something it is not. The Fed shouldn’t be selling “growth.” And the Chick-Fil-A folks should stick to selling sandwiches rather than basis points.
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About the Author:
Dr. George Calhoun, a graduate of the University of Pennsylvania, received his Doctorate Degree from the Wharton School of Business. He has served in multiple capacities in the Financial Sector and in the Wireless Communication Industry. He has authored multiple articles on subjects of interest to him and several books. His most recent book “Price & Value: A Guide to Equity Market Valuation Metrics” is available through the Publisher Springer/Aspress. Dr. Calhoun currently serves as the Executive Director of the Hanlon Financial Systems Research Center at the Stevens Institute of Technology and is an Advisory Board Member of Hanlon Investment Management.