CAMS Weekly View from the Corner - Week ending 9/20/24
September 23, 2024
Last Wednesday the Federal Reserve informed the citizenry they reduced their benchmark Fed Funds Rate by ½%. The Fed went with a deeper cut than general consensus to begin this now official interest rate cutting cycle.
The “interest rate cutting cycle” phrase is an important detail as it offers there is little expectation this is a minor trimming around the edges of monetary policy but rather an entirely new cycle that has begun.
For Chairman Powell’s part he offered this type of language in the press conference following the Fed’s decision of cutting by half percent.
For today’s edition we will stay high level and look at price inflation, cutting rates and recession interactions when in rate cutting cycles. Relatively recent history of the previous near 40 years offers some interesting views.
First let’s backtrack a bit to add in some backdrop perspective.
Over the previous two-plus years we have offered as asides within numerous editions that this price inflation era was likely to remain with us until a recession occurred. We use history as our guide when offering this view. True price inflation eras do not leave the scene easily.
On a personal note I continue to ask why are we talking about and now actually cutting interest rates. I’ve listened to, discussed and debated the various angles supporting this action and afterward remain left with the same view – why are we cutting interest rates at this juncture?
While reading that you may have a kneejerk mental reply – “To cut mortgage rates” (as one example) of which I offer, hold on now.
In our previous edition we shared a bit about general financial conditions and how tightening or loosening those backdrop economic conditions is the overall aim of the Fed when they are raising or cutting their Fed Funds rate.
We shared how broad collective markets’ participants play a tremendous role in tightening or easing general financial conditions in how they deploy capital throughout various markets.
We then shared one specific example in how the 15 Year Average Mortgage Rate has been reduced by nearly 2% over the previous year as these participants maneuvered capital within the Treasury bond market. (This all while the Fed did not lower their Fed Funds rate.)
By bidding up these bonds they left in the wake of their market operations a reduction in Treasury yields (think interest rates) and through these mortgage rates benchmarked to said bonds reduced as well.
It is a bit more involved than this general description but our focus is to emphasize market participants play a notable role in establishing mortgage rates as well as many other interest rates.
With this there is not absolute certainty that the Fed cutting rates will motivate further market positioning by collective participants resulting in lower bond yields and hence lower mortgage rates from here.
This is not a prediction rather it is a counter thought to the kneejerk view that “The Fed cutting rates equals guaranteed lower mortgage rates.”
(To emphasize, we note mortgage rates as only one of many examples of market participants playing a notable role in setting general financial conditions be it tightening or easing them.)
What could get in the Way of this Expectation?
Two words: Price inflation.
On a yr/yr basis the Consumer Price Index (CPI) stands at a 2.6% growth rate. The CPI Less Food & Energy (known as the “core inflation” rate) stands at a 3.3% growth rate – far north of the Fed’s 2% Target level. This growth rate increased with the most recent release.
Continuing for perspective – the Owners’ Equivalent Rent measure which is the dominating component to measure housing price inflation within the CPI calculation stands at a 5.4% growth rate which also increased with the most recent update.
Lastly, CPI Services (a broad sub-component area of CPI) stands at a 4.8% yr/yr growth rate. In this component’s case it has been stuck in this general range for the previous year. Think no progress. Services represent a tremendous percentage of economic activity within the United States.
For their part Services price inflation is refusing to go away. There are other measures we can point to as well which in sum leave the question - through the lens of price inflation - why are we cutting interest rates?
At this juncture the question is not applicable pragmatically speaking because we are now in a new rate cutting cycle per the Federal Reserve’s Chairman.
So let’s look at the past near 40 years and see what has occurred with a new notable rate cutting cycle as viewed through price inflation and the health of the economy.
This dates back to the latter 1980’s and is admittedly a busy looking chart with our added annotations so let’s break it down.
The blue line represents price inflation via the well recognized CPI measure. The red line is the Fed’s benchmark interest rate – the Fed Funds rate.
We have four free floating red arrows pointing to the various interest rate cutting cycles over the previous few decades.
In each isolated case we have encircled the CPI measure (blue line) while adding a red downtrend arrow on the Fed Funds rate (red line.) In each case the rate cutting cycle was notable and consistent.
In each rate cutting cycle price inflation (blue line) was unable to move lower on a trend basis and ultimately found a way to move higher as rates were reduced. The one exception was the beginning of this 21st century whereby price inflation gyrated around in a sideways fashion.
In all four rate cutting cycles price inflation did not start a solid downtrend to the point of behaving within the Fed’s 2% (and lower) realm until a recession arrived onto the economic landscape.
The faint blue/grey shaded vertical bars depict recessions. We can see price inflation (blue line) moved notably lower upon entering into the shaded vertical bars, i.e. recession.
Overriding Observations
There are many views that can be extracted from the above history of rate cutting cycles. While the above four cycles all devolved into recessions each one was distinctly different in how and why the economy moved toward recessing.
Price inflation has been a central issue for the citizenry in recent years which has carved out a historical inflationary era. Regardless of narratives the price inflation backdrop has not been laid to rest.
The central question is can we see this price inflation era finally end while the Fed is in a rate cutting cycle. The history above offers rate cutting cycles do not offer a deathblow to price inflation ultimately it is recession that delivers the knockout.
If we do not move to recession and price inflation remains an issue for the citizenry then the Fed’s ability to cut rates as much as hoped will be in peril.
If this occurs (that is no recession and continued price inflation issues) collective market participants will take note as they are operating within various markets, to include the bond markets which play a notable role in setting general interest rates to include mortgage rates.
In addition, if this economic landscape were to unfold (again no recession and on-going price inflation issues) then it may be a stretch to expect notable reductions in general financial conditions from here.
The assumption is the Fed’s 2% Target will be reached as we move forward and it will not be a touch and go – that is hit 2% and then find its way back to 3% again. That’s the assumption.
Reality may present a different picture and if it does the overall interest rate storyline may not be moving consistently lower as many expect to include the Fed’s Chairman.
Our bottom line is just because the Fed has begun an interest rate cutting cycle does not mean price inflation is over or that recession will be avoided. There are many moving parts to this storyline. Fed cutting cycles do not equal assured economic nirvana going forward.
Let’s hope this era will be different than the eras presented above and the Fed is correct in their timing of beginning this interest rate cutting cycle.
Ultimately it remains all about price inflation.
I wish you well…
Ken Reinhart
Director, Market Research & Portfolio Analysis
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