Fed Cutting Rates and Economic Growth: What To Expect?

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At the end of October 2019, the Fed cut interest rates for the third time, ending for now the mid-cycle adjustment that gave some relief to markets and the economy.

In the last decade we got used to an increasingly intervention of central banks in the economy and we place a lot of attention on their moves and on what they say they are going to do.

Today, the Fed is supporting the economy by cutting interest rates for the third time in row, meanwhile the economy keeps expanding and stocks are at record highs.

In contrast, I would like to just remember the fact that at the beginning of the year, the path was one of rising rates.

Should we really focus on what central banks are doing from month to month?

What should we expect for the future, both short-term and long-term?

Keep The Economy to Expand

The environment in which those rates cuts are taking place is the current bull market originated from the ashes of the 2007-2009 financial crisis, that just became the longest period of growth in U.S. history.

However, according to what is normal to see towards the end of the cycle, uncertainties about its continuation start to arise and cracks starts to show.

Slowing global economic growth coupled with geopolitical risk and mixed signals from different economic indicators are signs of stress. We have seen how those uncertainties translate into market movements at the end of 2018.

The average economic growth has slowed down in 2019 and immediately the Fed jumped in and pushed on printing more and more money and lowering interest rates trying to keep the economy going.

This works, at least in the short-term and it is a way that at least keeps the current situation as it is or even improves it a bit, fostering economic growth.

Market Reaction and Investors Sentiment

After 3 cuts in a row, the reaction of stock markets is to the upside. Stocks keep going up as the Fed adopts a more loose monetary policy and record all times highs.

Has the fed cut rates not to disappoint the markets (that were expecting a cut with a probability higher than 90%)? That’s a possibility.

Anyway, the S&P 500 is up 22.3% since the beginning of the year and what is even more astonishing is that also big banks have bullish view on the index.

Do you know what is insane? They might even be right! 

The strategy of mid-cycle adjustments was already used in the past to prevent slowdowns, historical data show that the market tends to extend its gains after three consecutive interest-rate cuts of a quarter percentage point.

Do you feel like jumping on the S&P 500 in order to make crazy returns? It may well happen that the index reaches 3200 or more by the end of the year, the real question is what happens next.

Remember the market can remain irrational longer that you may think. The nature of the economy is to be cyclical, the downward cycle can be postponed and it is exactly what’s happening now. Usually when it is postponed the next downturn is definitely worst and keep on postponing adjustments in the economy can seriously end up very bad.

Economic Cycles Duration

The truth is that business cycles are not infinite and eventually will come to an end. It is not anyone fault, it is just how things are going

Right now the music is still playing, but if you know that it will come to an end you can position yourself 1) not to be wiped out, 2) to take advantage of the situation.

If we take a look at today’s economy we see by what’s happening that everyone is trying to prolong the cycle as long as possible

Think of interest rates cuts, tax eases, the waves of buybacks… the fact that economic cycles will come to an end is well known to anyone and should not come as a surprise.

The behavior of 2019’s Fed really resonate with Alan Greenspan’s policies back in 1995-1996. At the time, the same strategy of mid-cycle adjustment rates cuts was implemented. It was made to avoid economic downturns in the short-term, exactly like today’s 3 cuts in a row.

What’s interesting is the view that Alan Greenspan, the then president of the Federal Reserve, had on “why do business cycle expansions come to an end”. (here is the transcript)

A goodly part of the weakness that we have been seeing probably reflects the fact that there is an ultimate life expectancy to a business cycle in much the same sense that it probably exists in human beings. The expansion cannot go on continuously; something will go wrong.

Do we now have the extraordinary capability needed to fine-tune the system to make a cyclical expansion go on indefinitely? I doubt it, but it is hard for me to judge how long this cyclical advance will continue.

Alan Greenspan

In his view the economy can be helped for a while in the short-term but eventually the business cycle comes to an end. 

It appears that today’s Fed in is the “temporary aid to the economy phase”, however, nobody knows how things will play out, not even the central bank.

What we know is that monetary policy can influence the economy making more easy to access money, but at the end of the day if you get a long-term perspective, debt can’t replace productivity as the driver of growth.

What To Expect From Monetary Policy?

The year began with a clear trend of rising interest rates, the view was for indefinite economic growth and the most appropriate moves were hikes. 

In a matter of months, the Federal Reserve started to use its forward guidance to point out the willing “to use our tools as appropriate to sustain the expansion” and started to respond to slowing down economy through lowering interest rates.

Long story short: we find ourselves today with a brand new line of monetary policy intervention and three interest rates cuts.

In conclusion, they don’t know what they will do. And they also clearly stated it.

The Committee will continue to monitor the implications of incoming information for the economic outlook as it assesses the appropriate path of the target range for the federal funds rate”.

This leaves the door opened to anything. And they stated this too.

Of course, if developments emerge that cause a material reassessment of our outlook, we would respond accordingly,” Powell said. “ Policy is not on a preset course.”.

So What?

When it comes to trying to understand what will happen in the economy it is very easy to shift the attention to the short-term.

However, you can’t just project the current scenario for other 5-10 years.

If you consider the bigger picture it is easier to realize that no matter what happens today or tomorrow, the economy works in cycles and these economic cycles are governed by a succession of causes and effects.

When a huge set of imbalances is in place, sooner or later we are going to have to deal with the problem.

And here I invite you to consider two things: first, the starting point could be worse than 2008, second, there is very little space of maneuver for monetary policy given the fact that interest rates are already incredibly low. 

Central banks, not only the Fed, could be far less effective when the next crisis shows up.

In the end, considering the increasingly high levels of debt in every area or the economy, public, businesses and consumers, there is only one possible (or politically acceptable) answer when we enter the crisis.

In conclusion, I’d like to remind that I am not here to sell panic. I just want to provide a view that focuses on a bigger picture to make sense of the long-term trends that are taking place. 

I would like you to just realize that economic growth, markets, interest rates, inflation … everything in the economy is cyclical and whatever trend doesn’t last forever

If you recognize those facts and incorporate them into your investing strategy, you can position yourself to be protected and take advantage of what, sooner or later, is going to happen anyway.

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