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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
“It doesn’t matter when the Federal Reserve starts cutting rates. What really matters is where they finish.” That is one view that is being heard around Wall Street.
At first glance, this advice serves as a timely caution for the many market participants currently obsessed with whether the Federal Reserve, reassured by the latest inflation data, will begin its rate-cutting cycle in September or wait longer, as several Fed officials suggested last week.
However, this opinion overlooks the significance of the timing of the first cut. In current circumstances, the timing is crucial for determining the cumulative magnitude of the cycle and the economy’s wellbeing.
The usual argument for the importance of timing posits that the first rate reduction allows markets to price the entirety of the cutting cycle with greater confidence. This seems less important given today’s overly data-dependent Fed, which has refrained from taking a strategic view and, regrettably, seems unlikely to change this approach any time soon.
This lack of policy anchoring has robbed the fixed-income markets of an important steer. You see this in the behaviour of US treasury yields, be it the policy-sensitive 2-year bond, or the 10-year which captures more comprehensive market views of the whole rate cycle as well as inflationary and growth outcomes.
In just the four weeks before the last Fed policy meeting, the 2-year yield fluctuated significantly: rising to almost 5 per cent, then falling by 0.26 percentage points, increasing by 0.18 points, and dropping again by 0.22 points to a low of 4.67 per cent. The 10-year yield exhibited similar volatility, though with larger magnitudes.
The stronger argument for the importance of timing relates to the state of the economy. Mounting, though not yet universal, data signal economic weakening, including deteriorating forward-looking indicators. This has coincided with a significant erosion of balance sheet buffers held by small businesses and lower-income households. The vulnerabilities, likely to increase as more of the lagged effects of the large 2022-23 hiking cycle take hold, come amid significant cyclical economic and political volatility, as well as transitions in areas such as technology, sustainable energy, supply chain management and trade.
There is also the historical perspective suggesting that a timely rate cut contributes to better economic outcomes. As Bob Michele of JPMorgan emphasised in a Bloomberg Television interview last week, a swift rate cut played a significant role in delivering a “soft landing” after the 3 percentage point hiking cycle in 1994-95, a rare occurrence in history. This historical precedent should instil a sense of optimism, suggesting that a well-timed rate cut could potentially lead to a similar positive outcome in the current economic landscape (a soft landing probability that I place at 50 per cent right now).
Given the inflation dynamics, pushing back the first rate cut increases the likelihood that, ultimately, the Fed will need to cut more to minimise the risk of recession. This scenario would constitute an inverse of the Fed’s initial 2021-22 policy mistake. By mischaracterising then inflation as “transitory” and delaying its policy reaction, the Fed had to increase rates aggressively by over 5 percentage points, including four successive hikes of 0.75 percentage points.
If, this time around, the Fed is forced into a large cutting cycle due to a delayed start and accelerating economic and financial weaknesses, it would also have to end up cutting by more than necessary based on longer-term conditions. This follows the previous upside overshoot that exposed pockets of financial vulnerability and, internationally, the policy challenges facing many other countries.
Once again, vulnerable households and small businesses would be most exposed to such an overshoot. The benefits of lower rates would be overshadowed by increased income insecurity or outright unemployment.
Rather than a given, the terminal rate for the upcoming Fed rate reduction cycle depends on when it starts. The longer central bankers wait to cut, the more the economy risks unnecessary harm to its growth prospects and financial stability, hitting the more vulnerable segments particularly hard. In the process, the Fed would be stuck again with a reactive policy reaction that firefights rather than a more strategic one that guides the economy to the soft landing many of us are hoping for and the world desperately needs.
