Federal Reserve Faces Pressure as Inflation and Debt Concerns Mount
Last week, GnS Economics predicted that the Federal Reserve would implement a 25 basis points (bps) rate cut. Our reasoning behind this forecast is grounded in recent economic indicators. Specifically, the 'super-core' inflation, which measures services inflation excluding energy, showed a notable rise of 4.9% year-over-year and 0.4% month-over-month. This monthly increase was the largest since April, and based on this data, we believe it extinguished any possibility of a 50 bps cut. Federal Reserve Chair Jerome Powell has emphasized the significance of the 'super-core' as a key factor in projecting core inflation trends. Given this, we maintain our position that a 25 bps cut is more likely.
From an economic standpoint, the numbers support this forecast. Inflationary pressures are clearly mounting once again. Retail sales and industrial production figures, which came in stronger than expected at 0.1% and 0.8% month-over-month, respectively, further support this. Additionally, the broader U.S. economy shows signs of recovery, with some positive indicators in the private sector suggesting that a recession may be nearing its end, although risks remain. Credit data has also shown improvement, and the Fed is undoubtedly taking this into account when considering its next move.
Historically, the last time the Fed implemented a 50 bps rate cut was in October 2008, shortly after the collapse of Lehman Brothers during the height of the Great Financial Crisis (GFC). It is important to remember that a 50 bps cut is generally considered a "panic cut." This raises the question: why would the Fed feel the need to panic now?
There are likely four primary reasons behind the Fed's current actions. First, the Fed is incurring substantial losses from its holdings in U.S. Treasuries and corporate bonds, which were purchased when interest rates were lower. As rates have risen, the value of these Treasuries has plummeted, resulting in significant losses. Second, political pressure may be at play, with the Federal Reserve under pressure not to destabilize the markets ahead of the upcoming presidential election. Third, the Fed appears to be genuinely concerned about the state of the economy, particularly regarding the growing debt levels. Lastly, there are ongoing concerns about fragility in the banking sector.
The Fed's massive losses from its bond holdings are a key driver behind its desire to lower rates. By cutting rates, the Fed can attempt to boost the value of the Treasuries it holds, which could help alleviate some of its financial burden. However, labeling these losses as "deferred assets" on the balance sheet only delays the inevitable need to address this issue.
While markets and some politicians had anticipated a 50 bps rate cut, such a drastic move might have backfired by signaling that the Fed is deeply concerned about the economy's health. As I mentioned in a recent piece, while banks appear somewhat optimistic and have eased lending standards, this optimism may be misplaced. With high levels of corporate and household debt, there is little room for further leveraging, which could lead to tightening credit conditions and softening demand for loans in the future.
The Fed likely recognizes the risks posed by excessive private and public debt. If interest rates remain elevated, defaults could rise, particularly on U.S. sovereign debt, which would inflict serious damage on the economy. Moreover, U.S. banks continue to grapple with significant unrealized losses, primarily due to the same issue the Fed faces—declining Treasury values. The outflow of core deposits from the banking sector, as noted in our August World Economic Outlook, remains a concerning trend, reflecting weakening confidence in the system.