Why the Fed’s Rate Cuts Might Fail Again: Lessons from 2000 and 2008

The University of Michigan Consumer confidence survey for March plunged to 57.9 versus the estimate of 63 and 65.7 in the month prior. And yet, inflation expectations in the same survey hit a 32-year high of 4.9%. Stagflation is the word that comes to mind when defining this data. And, stagflation is a very difficult condition in which to become bullish about stocks.

The economy is slowing rapidly due to:

• The raising of tariffs which increase taxes and create economic friction.
• A reduced labor force; even if there are obstacles to government firings they are no longer in the business of hiring, and the borders are now pretty much closed.
• We also have zero growth in public sector spending.
• Stock market liquidity is drying up; the money in the Treasury General Account and in the Reverse Repo Facility have nearly evaporated.
• The Real Fed Funds Rate is in positive territory and has been so for the past two years.
• The Fed continues to reduce its balance sheet, albeit on a slower pace. It has so far destroyed over $2.2 trillion of that so-called high-powered money.
• Bank lending standards have begun tightening again.
• And finally, there is the reverse wealth effect from home and stock prices that have topped out and are now rolling over.

The conclusion of the Fed’s March meeting was to keep rates at 4.25-4.5%. But there were big cuts in the GDP forecast to just 1.7%, down from 2.1% in the previous meeting, with a slight increase in the unemployment rate up one-tenth to 4.4%. Yet, inflation also got upgraded to a 2.8% annual pace, up 0.3 percentage points from their previous estimate. Powell also stated he will slow the pace of QT to just $5 billion per month of Treasuries from the previous $25 billion but will maintain its goal of shedding $35 billion per month in MBS starting April 1st.

Powell said in the press conference that the FOMC predicts inflation will return to its 2% target level sometime in 2027. So, here’s a question for Mr. Powell: why is the Fed in a rate-cutting cycle when, by its own guess, CPI will remain above the 2% target for 6 years?

This rate-cutting cycle is supposed to supply Wall Street with the so-called Fed Put. The belief is that the Fed will quickly cut rates to avert both a recession and a bear market. However, this has proven to be false historically speaking.

Some here is the truth about the Fed "PUT". The Fed has historically been very late in cutting interest rates because inflation is a lagging economic indicator, whereas the market is a forward-looking indicator. The Fed is focused on CPI prints that are reported to have a month’s lag and are the result of monetary impulses that are even further lagging. Powell continues to miss the disinflationary and deflationary forces that are concomitant with a recession and the end of the liquidity cycle. What looks like stagflation now can quickly morph into deflation as the economy falters.

But how effective has this Fed “PUT” been in the past? The Fed started cutting rates in December of 2000 to avert an incipient market meltdown and recession. It dropped the overnight lending rate from 6.5% to 1% by November 2002. However, that didn’t stop the S&P 500 from dropping 50% by March of 2003. Likewise, the Fed began cutting rates in September 2007 to boost housing prices and bail out banks. Chair Ben Bernanke cut the Fed Funds Rate from 5.25% to 0% by December 2008. However, that didn’t stop the S&P from shedding 57% of its value either. The point here is that the Fed is always behind the curve.

Investors should take little solace in the fact that the market bounced back in the ensuing six years. Not only is losing half of your money and waiting six years for a 100% rebound very painful, but it may also take a lot longer to get above water this time. This is because the bubbles are much bigger and exist concurrently. Housing and equities are in huge bubbles. And, there is a credit bubble as well. The US has $2 trillion deficits, and our $37 trillion National debt is 123% of GDP. Therefore, the bond market might fracture during the next recession when the annual deficit surges toward $6 trillion. Meaning yields could spike much higher on the long end of the yield curve. Thus, countervailing the belated efforts of the Fed to lower the Fed Funds Rate.

Actively managing your investments around these boom/bust cycles has never been more critical.