Markets tend to remain calm when the economic environment is predictable and lives up to expectations. Surprises, on the other hand, trigger bouts of volatility as Wall Street scrambles to gauge the spin on a market-moving curveball.
Prior to the Federal Reserve meeting Wednesday, the market had priced in – with near 100 percent certainty – a rate cut of at least 0.25 percentage points. On Wednesday, Fed Chairman Jerome Powell threw investors a fastball right down the center of the plate after announcing the central bank would drop its key rate by 0.25 percent, falling right in line with market expectations.
“The Fed followed through with a rate cut, largely as expected, but we were hoping the Fed would go even further and introduce a little ‘shock and awe’ with a deeper 0.5 percent cut,” says Brent Schutte, chief investment strategist at Northwestern Mutual. “A larger preemptive cut, in our view, would have signaled the Fed was serious about sustainably hitting its 2 percent inflation target, which we think is crucial to achieve before the next recession occurs. We’re not so sure this smaller cut sends that same message.”
A VANILLA-FLAVORED RATE CUT
The Fed typically cuts rates when it needs to juice growth, but by most measures the economy is still strong and growing modestly. If that’s true, why were policymakers and investors expecting a monetary assist? Well, two things really: persistently low inflation combined with the Fed’s proactive approach to preventing economic calamity long before it can establish roots.
Schutte believes the Fed has fundamentally shifted its calling from fighting inflation, as it did in the 1980s, to boosting it. The Fed’s focus is no longer about moderating business cycles (aggressively tamping down excesses) but is instead aimed at enhancing conditions to keep an expansion – like the record-setter we’re experiencing – chugging ahead for as long as possible.
During testimony before Congress earlier in this month, Powell echoed this view, saying the Fed would remain “accommodative” with its policy and help the current “expansion continue as long as possible.” Powell pointed to trade fears and slowing global growth as potential threats to the U.S. economy. He also reaffirmed the Fed’s commitment to hitting its 2 percent inflation target, which has thus far proven elusive. Investors, reading between the lines, interpreted this as all but guaranteeing a cut was coming.
July’s cut is largely viewed as an insurance policy of sorts, preemptively shielding a strong U.S. economy from trade and global growth contagion. It’s like grabbing an energy drink to perk you up for the rest of the day, but at the first sign of fatigue rather than after you’re already exhausted. It remains to be seen whether the Fed’s modest approach will jolt inflation to its 2 percent benchmark.
“We don’t think the Fed can risk allowing a recession to occur before inflation sustainably hits the central bank’s 2 percent inflation target,” says Schutte. “Fed decision makers have spent the past few years staking their credibility on meeting this goal, and if they don’t meet it, you start to wonder what that means about their future operating strategy. This might be 25 basis points wasted, and I think it would’ve been more effective to shock the market a bit with a deeper cut.”
WHY IS THE FED TARGETING 2 PERCENT INFLATION?
There are a few reasons the Fed targets a 2 percent inflation rate. First, and perhaps most obvious, is to prevent deflation, or falling prices for goods and services. While mild price declines may be good for consumers short term, persistent deflation will eventually have a material impact on businesses as they are forced to lower prices and, in turn, generate lower profits. As profits decline, businesses reduce production, which typically leads to workforce reductions. When more people are out of a job, demand for products continues falling as consumers cut back on spending or even have trouble paying back debts.
Second, consistent, sustainable inflation gives the Fed a little more wiggle room to cut rates if a recession does indeed occur. For example, if inflation were far exceeding the Fed’s benchmark it would have more reason to raise rates. And, lastly, setting and hitting an interest rate target helps the Fed manage public expectations about inflation, because, reflexively, inflation expectations are an important determinant of actual inflation. By hitting its 2 percent target, the Fed anchors public expectations, supports price stability and maintains its policy-setting credibility.
ON THE BRIGHT SIDE
Despite uncertainty about global growth and trade policy, job openings continue to grow, and unemployment remains low. GDP growth is holding steady. Consumers are spending, and they are more financially fit than they’ve been in years. Signs of excesses in the economy are in short supply. So, in other words, the economy is still showing strength even after a steady diet of rate hikes since 2015 (four last year alone) and a cloud of uncertainty.
A 0.25 percent cut simply unwinds one of those 2018 hikes. Though it’s not quite what Schutte and team expected, it does make money cheaper to borrow and may ultimately encourage businesses, consumers and investors to keep pumping money into the system. If it works, a modest approach today could provide the Fed more flexibility if it needs to intervene once the economy reaches a real soft patch in the future. Of course, at that point, some argue it may already be too late.
Although the Fed’s decision may trigger some volatility, that’s par for the course if investments are just part of a larger, comprehensive financial plan. Stocks remain the best-performing asset class over the last century, not because the road is smooth but because they’re inherently risky. Holding stocks for the long-run – five years or more – puts investors in a better position (though not guaranteed) to be rewarded for their patience.