Back to the Future… Have we been here before?
ref: - "Rates Traders May Be Thinking of a 1998-Style Fed
Rate Reduction”, Bloomberg Business
For all the recent ebullience in US equities, if there's one thing
the economic commentaries are not short of its doom-mongers. Well, it's not as
though there aren't plenty of reasons to take a dark view of the economic
future should one be so inclined, and more disappointing data from Germany
yesterday only confirmed the fact that the Eurozone, in particular, faces a
real struggle to recapture the path to solid economic growth.
Europe is by no means alone but sometimes one has to look past the
worried faces and remind oneself of exactly where we are right now. Anyone
doing that might notice that the Chinese Slowdown story that undermined global
growth expectations might not be as severe as originally thought. More to the
point, what no one could deny is that in the biggest economy of all, the United
States, things are still purring along pretty nicely. Markets may have been
given a huge boost to recover all the losses of late last year and to regain
new record-high ground by the halt to the Fed's rate tightening cycle, but the
evidence of underlying strength is still strong too. Against quite a few
expectations, the latest corporate earnings season is suggesting that the real
economy is still robust, and it's not just a case of over-excitable stock market
prices.
So why then, if things in the States are still going so well, are
futures markets suggesting that the US Federal Reserve will cut rates by a
quarter point this year? There are a few answers to that, not counting the
slightly mischievous suggestion that they might do so just because Donald Trump
tells them to. One might be that futures markets are just plain wrong, of
course. Another one is that the Fed might have to cut rates as a pre-emptive
move to counter headwinds from elsewhere... in other words, it would be a
preventative move to protect and maintain the strength the US economy rather
than a reaction to evidence of a domestic slowdown.
If that should happen, it would mirror events of 1998 when the Fed
lowered rates to protect the economy from slipping into recession as a result
of problems overseas… and they were pretty serious problems, too. The Fed had
to consider both the Asian financial crisis and Russia's debt default. If you
throw in the collapse of Long-Term Capital Management at home too, you can see
the appeal of pre-emptive action. Today's Fed will be looking at Europe and a
Japan still stuck in a deflationary rut rather than those problems of 20 years
ago or so, but may come to the same conclusion about how best safeguard US growth.
After all, it worked back then in similar conditions of a strong domestic
economy (after a long period of expansion), low inflation and record or
near-record stock prices.
One could always say the same thing of course, but it seems
particularly true right now that all three possibilities for US rates in 2019
are still on the cards -- a hike, stay where they are, or a cut. If it's the
latter, protection against those global headwinds may play a big part in the
decision. But it's worth remembering that with rates currently at 2.25% -
2.50%, the Fed has a lot less room to play with that was the case in 1998 when
rates were at 5.50%. And besides, it's hard to get away from the view that the
inflation rate, both current and expected, will be the biggest factor in the
Fed's thinking.
Stubbornly low inflation may be the thing that forces the Fed to
cut. But then again, the old rulebook about inflation has been thrown out and
these days nobody seems very certain about how it works. Many economists are
still convinced that the US' tight labour markets and sustained wage growth
must -- simply must -- push inflation higher sooner or later. The Fed may be
thinking about tolerating a shortish spell of inflation above its 2% target to
make up for the long periods of below-target readings but that surely wouldn't
last long.
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