Federal Reserve's Puzzling Lean Towards Rate Cuts Despite Loose Monetary Policy and Positive Economic Indicators Sparks Debate

Federal Reserve's Puzzling Lean Towards Rate Cuts Despite Loose Monetary Policy and Positive Economic Indicators Sparks Debate 

Despite undergoing one of the quickest cycles of interest rate increases, the current monetary policy remains unusually loose. There is persistent pressure for rate expectations to rise further as the Federal Reserve cautiously shifts its stance from December, leading to more pronounced curves in fed funds and SOFR futures.

An analogy fitting for this situation is the well-known experiment where observers, focused on counting basketball passes, fail to notice a gorilla walking through the scene. Similarly, amidst the analysis of data and language from the recent Fed meeting, it's easy to overlook the fact that overall policy remains highly accommodating despite a significant rise in rates. The Fed's actions, which include over 500 basis points of rate hikes, have largely gone unnoticed, akin to the unnoticed gorilla.

Although the Fed kept rates steady at 5.5% as expected and forecasted three rate cuts for the year, a broader examination reveals that monetary policy has actually loosened considerably in this cycle, contrary to expectations of tightening. This is evident in indicators such as the Effective Fed Rate, which has exhibited a noticeable trend of easing, unlike in previous rate-hiking cycles.

Given the context of the December pivot, made despite indications of no immediate recession and better-than-expected inflation and growth data thereafter, the potential decision by the Fed to cut rates seems perplexing. Despite positive economic indicators, the Fed may still consider rate cuts, which could be a misstep, especially considering the significant decline in the Effective Rate without any rate cuts being implemented yet.

The presence of the "gorilla" in the economic scenario is evident in various aspects, such as the discrepancy between cyclical and acyclical inflation. While acyclical inflation has reverted to pre-pandemic levels, cyclical inflation remains elevated, indicating that the Fed's actions haven't directly addressed inflationary pressures.

Furthermore, when accounting for borrowing costs, inflation measured with housing borrowing costs included remains high, suggesting a misalignment between the Fed's policy decisions and economic reality.

The lack of anticipated slack in the economy, despite extensive rate hikes, raises doubts about the effectiveness of monetary policy. Government deficits have prevented significant increases in unemployment or declines in job openings by facilitating job retention, as illustrated by the Kalecki-Levy equation.

The resurgence of EPS growth and its correlation with job openings further emphasizes the intricate relationship between economic indicators and monetary policy. Despite factors such as China's sluggish recovery impacting inflation, the Fed's sole focus on inflation might be shortsighted, especially given the unlikelihood of a near-term recession.

Nonetheless, the Fed might still opt for rate cuts, possibly due to overconfidence or weak justifications, which could increase risks in asset markets, including stocks and cryptocurrencies like bitcoin.

In conclusion, the potential decision by the Fed to cut rates before the year's end appears puzzling, especially given the prevailing economic conditions. Markets may seek to adjust expectations by reducing the anticipated number of rate cuts to restore a sense of stability.