The Fed’s Big Cut Meets Cognitive Dissonance

Stocks finally got the rate cut they longed for Wednesday, when Bank Indonesia cut its policy rate by -0.25 percentage point (ppt) to 6.00%. Oh, and the Fed trimmed the fed-funds target range by half a point, to 4.75% – 5.00%. Markets’ reaction was as random as usual, once again demonstrating the futility of trying to predict and time Fed moves. Headlines, meanwhile, can’t seem to decide whether the large cut is bullish (Lower rates! Partyyyyyyyy!) or bearish (eek what trouble doth the Fed see?). Fed head Jerome Powell seemed a bit stuck on that fence in his post-decision press conference. Our suggestion: Tune it all down. There is no evidence a -50 basis point (bp) cut means the Fed sees surefire trouble—not that Fed people really possess special insight—and markets have already demonstrated rates aren’t all-powerful.

You can see this in both longer- and short-term returns. The Fed started hiking on March 17, 2022. Stocks were about two and a half months into a shallow bear market at the time, and we think it is fair to say that the Fed’s about-face on inflation and rate hikes contributed to the sour sentiment that tugged stocks down. But a bull market began that October, soon lifting stocks to new highs and beyond. Accordingly, the S&P 500 opened Wednesday 34.5% above its pre-hike level.^[i] It rose 25.5% while the fed-funds range was at its apex, 5.25% – 5.5%.^[ii]

Or, consider markets’ immediate reaction, which illustrates how they had already priced this move into nothingness. When the Fed’s release hit the wires, the S&P 500 was about flat on the day. From there, it took a 12-minute round trip to about 0.8% and back to breakeven. Then a repeat of that trip, more or less. After a few more wiggles, it ultimately finished down -0.3%.^[iii]

Soooo … bullish? Bearish? Or is it just that some traders had BUY ON RATE CUTS programmed into their platform of choice, then others had SELL ONCE S&P 500 HITS XXXXXXXX, while others had BUY ON XXXXXXX, and round and round and round the algorithms went, chasing their collective computer-coded tails. Do you see a pattern there? Anything worth trying to time and trade? We don’t. Just a lot of nonsense we are happy to giggle at from our humble perch. Investors are always best off thinking long-term, targeting bigger, more lasting moves and leaving the cutesy trading to the traders, in our view.

The long-term view is what the legions of analysts covering Fed action tried to tease out as they sifted through the Fed’s statement, its dot plot of Fed members’ projections and Powell’s comments. We saw a fair amount of markets like low rates and wanted this really badly, so they got what they wanted, yay, bullish. There was also no shortage of commentary questioning what troubles the Fed sees ahead, particularly on the labor market front, given the official statement noted an “uncertain” economic outlook alongside slower hiring. The dot plot added to this, with projections shifting from 50 bps worth of cuts this year to a full percentage point by year end. Given stocks ended up negative, this narrative will probably win the day when the dust settles.

Some coverage noted the Fed’s history of starting loosening cycles with larger cuts isn’t confidence-inspiring. The past three happened in January 2001 (after the dot-com bubble burst), September 2007 (the dawn of the global financial crisis and recession) and March 2020 (the COVID lockdown recession). While mid-cycle cuts also began without bear markets or recessions, all started with 25 bp cuts. But a handy Wall Street Journal analysis poured cold water on this thinking, noting the Fed’s statements viewed their larger cuts as pre-emptive, not reactive.

Fed transcripts show as much. In January 2001, Alan Greenspan and friends theorized that with the Tech revolution speeding up economic trends and sentiment in general, it was necessary to make bigger and faster monetary policy changes than they normally would. In doing so, they expressed concern a large move “would give an indication that we do know something that other people don’t know or that we’re scared, neither of which is the case.”^[iv] In 2007, policymakers saw the larger cut as a return to the neutral rate (the hypothetical point where monetary policy neither stimulates nor constricts) and an insurance policy against potential future financial market turmoil after some Bear Stearns funds had blown up.

The Fed doesn’t possess special, insider information into the economy’s future health, either—perhaps best illustrated by September 16, 2008’s transcript. It features a combination of backslapping over a job well done in forcing Lehman Brothers to fail in the days before and some jokes about the economic downturn’s alleged lack of impact. “For example, East Bay plastic surgeons and dentists note that patients are deferring elective procedures. [Laughter] Reservations are no longer necessary at many high-end restaurants. And the Silicon Valley Country Club, with a $250,000 entrance fee and seven-to-eight-year waiting list, has seen the number of would-be new members shrink to a mere thirteen. [Laughter]”^[v] Shall we call those jokes ill-timed?

In the press conference, Powell took great pains to say the Fed doesn’t see trouble brewing. He talked repeatedly of a strong job market, saying, “There is thinking that the time to support the labor market is when it’s strong, and not when you begin to see the layoffs.” But then he flipped a little when pressed on whether September’s large cut was a way of making up for not cutting in July, conceding that if July’s allegedly weak jobs report had been out when the Fed met, they “might well have” cut.^[vi] It seems Powell, like most of his profession, is a two-handed economist.^[vii]

Maybe this is the start of a troublesome time and, in hindsight, the Fed will prove to have done too little too late. But that is always a possibility, regardless of a cut’s magnitude or whether the Fed cuts at all. Crucially, we don’t see much evidence this is the case. Not because the raft of economic data out this week were positive and beat expectations—sorry folks, it is all backward-looking—but because forward-looking measures look good. Lending conditions have improved, capital is flowing where it needs to go, and businesses are becoming less risk averse after two years of cutbacks to survive a recession that never came. The job market wobbles the Fed is eyeing seem more to us like an after-effect of that spell than predictors of future trouble, given employment is a late-lagging indicator.

So let the Fed hog headlines’ attention and give yourself a break. Whatever the economy and markets do from here, it really doesn’t matter much that rates are half a point lower than 24 hours ago. Today’s move was widely anticipated window dressing.