Markets Are “Weird,” But the Fed Doesn’t Care
The Fed is not cutting 75 basis points in September, and they’re probably not even cutting 50 basis points either. Here’s why.
The S&P 500 was down 9% and there was blood in the streets. It wasn’t down 9% on the day, not on the week, but 9% from its all time high. The truth is, everything is going to be okay. The Fed is not doing an emergency rate cut this week. They’re not cutting 75 basis points in September (sorry, Jeremy Siegel), and they’re probably not even cutting 50 basis points either. Here’s why.
The Fed, as Jay Powell explicitly told us last week, is “data dependent but not data point dependent.”
There’s big debate about Friday’s weak jobs report and whether it was skewed weaker by the Texas hurricane. We won’t know for sure until the August jobs report comes out in early September. But here’s the key point: when the data is noisy, the Fed isn’t going to obsess over one print, let alone take drastic action like an emergency or 75bps cut. Chicago Fed President Austan Goolsbee said as much this morning on CNBC: “The Fed's job is not to react backward looking to one month's numbers.”
The Fed is also not going to overreact to one report when other hard data tell a different story: +2.8% for second-quarter GDP, +2.5% AtlantaFed forecast for third-quarter GDP, TSA daily checkpoint numbers near all-time highs, and this morning’s ISM services beating expectations across the board. Today, the Federal Reserve also released its quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices, which notes that banks are no longer increasing loan rates and demand for loans picking up. Yes, there’s weak data out there, and yes, the economy is slower today than it was six months ago, but the logical deduction from a slowing economy is not “EMERGENCY RATE CUTS.”
We will be data dependent but not data point dependent, so it will not be a question of responding specifically to one or two data releases. The question will be whether the totality of the data, the evolving outlook, and the balance of risks are consistent with rising confidence on inflation and maintaining a solid labor market.
Chair Powell’s Press Conference. July 31, 2024. Transcript here (pg 4).
Most Fed cutting cycles fall into two categories. Either they’re responding to a substantial economic shock—think 2008 or the China virus in 2020—and they go big and cut aggressively. Or, they’re making smaller calibrations—like 1995, 1998, and 2019, where they cut by 75bps over the course of a few meetings. These cuts are designed to bring the Fed Funds Rate closer to “neutral,” the elusive rate that neither stimulates nor slows the economy. Neutral has always been hard to pin down, especially these days, but Jay Powell himself told us in September 2023 that “we only know [the neutral rate] by its works.” Essentially, you judge where neutral is by how the economy is responding to current rates. If the current Fed Funds Rate were above neutral (i.e. restrictive), you’d expect the real economy to show it: growth falling and unemployment rising. That hasn’t really been the case. This year, a 5.3% Fed Funds Rate has, again, come with +2.8% for second-quarter GDP, a +2.5% AtlantaFed forecast for third-quarter GDP, and an unemployment rate that is, yes, three-tenths higher than the Fed’s year end forecast, but also a labor market that seen over 1.4 million jobs added to payrolls year to date. Not great, but not terrible, and certainly not clear-cut evidence that the Fed is overly restrictive. Let’s look at the graph below.
It’s “Household Debt Service Payments as Percentage of Disposable Personal Income.” The shaded colors are Fed hiking cycles. What does it show? As the Fed hikes and interest rates head higher, consumers pay more in interest to service their debts as a percentage of their disposable income. That’s a feature, not a bug. The Fed wants to raise debt costs for consumers and business so they’ll cut back on their spending and investment, and in turn slow down the aggregate economy. Higher Fed Funds » Higher Household Debt Service Payments is what happened when the Fed raised rates in 1994, 1999, and 2004, but not this time around. Not only did the household debt service stat not increase after 500 basis points of Fed rate hikes, at 9.8% today it’s lower than the long-term average of 11%. That’s not exactly evidence of overly restrictive interest rates.
There are several reasons why the debt servicing stat has stayed constant despite aggressive Fed hikes in 2022-23, but here are two big reasons: 1. consumers (70% of GDP) locked-in low mortgage rates (the #1 consumer liability by far) so rising rates didn’t hurt and 2. consumers earned decent yield (4-5%) on excess cash because of rising rates and used that to support consumption. The same effects apply to businesses: they termed out debt, locked-in low rates, and earned 4-5% on their cash. Rate hikes, for the wealthy consumers and large businesses, were actually a good thing, even if they meant pain for low-income Americans. Alas, the Fed looks at aggregate data when deciding policy, so when 40% of consumption comes from the top quintile in America, the goods news from rate hikes benefitting wealthy Americans far outshines the pain felt by low-incomes Americans.
When I spoke at the 2023 Citi Equities Conference, I dubbed this phenomenon the “Fed’s Lemonhead problem,” because rate hikes, like lemonhead candies, were thought to be sour, but were actually sweet for the aggregate economy. Axios wrote about my theory here.
Small businesses aren’t really complaining about high rates either. Just four percent of small businesses said that financing was their top business problem in June. Compare that to inflation, which is still the top small business issue, with 21% of owners reporting it as their single most important problem in operating their business. Survey data from the National Federation of Independent Business (NFIB).
If the neutral rate is high and policy isn’t all that restrictive, as the evidence here suggests, then does the Fed really have confidence to aggressively cut, and potentially risk igniting another bout of inflation?
It doesn’t matter how much Fed Chair Jay Powell denies it, the Fed is a politically progressive institution. Here are just two stats to back this up: for every 1 Republican economist at the Fed, there are 10 Democratic ones.1 And 97 cents of every dollar donated by Fed staff goes to Democratic candidates or causes.2
The Fed’s undeniable political lean makes an emergency rate cut and/or aggressive rate cuts less likely for two reasons: first, if the Fed cuts aggressively, it could signal that there are hidden economic issues, causing the market to panic. Investors and businesses would ask, “What does the Fed know that we don’t?” It could suggest a real crisis rather than just market volatility, hurting Vice President Harris’ electoral chances since she’s the incumbent and, in the eyes of the public, bears responsibility for bad economic news. Second, it would open up a stellar attack line for President Trump: “the economy under Biden and Kamala is so bad the Fed has to cut as aggressively as it did during the 2008 crisis.”
I doubt politics would be a major factor in determining the size of a September rate cut, but in a close-call, politics could certainly play a role. The Fed would never admit it, of course. It would never show up in the transcripts, let alone their official post-meeting statement, but that doesn’t mean that it wouldn’t be a factor in their decision. I’m amazed at how many “expert economists” will deny the Fed’s political one-sidedness when the data is undeniable and especially when former high-ranking Fed officials have said the quiet part out loud. Just look at what former New York Fed President Bill Dudley said in 2019 about how the Fed should respond to Trump.
The Fed, for the right reasons or perhaps even the wrong ones, won’t be doing an emergency rate cut or cutting 75 in September. If the hard data continue to be decent (not great, but not awful), they’ll likely cut 25 in September, November, and December, consistent with their “calibration rate cuts” playbook from 1995, 1998, and 2019. That would mean a total of 75 basis points of cuts by year end, which is miles away from the 125 basis points by year end that markets are pricing as I write. Happy to talk about how I’m structuring this trade. My email is james@azoriapartners.com
I’ll end with this quote from Austan Goolsbee, president of the Federal Reserve Bank of Chicago, who told the New York Times this afternoon: “We’ve got to be monitoring the real side of the economy: There’s nothing in the Fed’s mandate that’s about making sure the stock market is comfortable.”
He’s right: the Fed’s job is not to bail out hedge fund managers or Heads of Macro (wherever they be), but to make good policy so teachers in Cincinnati and firefighters in Coeur d'Alene can go about their lives, work hard, and earn a decent living. It’s never too late for the Fed to get it right, even if they got it horribly wrong after the pandemic. Headline CPI hit 5% in June 2021, and the Fed didn’t end up raising rates (off of zero percent, mind you) until March 2022, nine full months later. They pushed the transitory lie and ran cover for President Biden and Speaker Pelosi’s reckless American Rescue Plan (ARP), a misnomer if there ever were one. By March 2021, when ARP was signed into law, there was nothing to rescue. Unemployment had fallen by more than half; over 150 million Americans had immunity to the virus, which itself turned out to be a nothing-burger; and business largely re-opened across the board.
Bidenomics has been an abject failure. I told President Trump as much when I saw him in June. Read Scott Bessent’s excellent essay, “The Fallacy of Bidenomics”, for more.
Markets may be “weird” these days, but there’s nothing “weird” about low inflation, good-paying jobs, and Making America Great Again.
I’ll share more about what our team is building at Azoria once we finish up our equity raise. Here’s a short video on our forthcoming ETF called “Azoria Meritocracy.”
All my best,
James T. Fishback
X: @j_fishback