The Federal Reserve’s Jumbo rate cut comes with great risk

The Federal Reserve’s long-awaited interest rate cut campaign kicked off with a bang after Jerome Powell and the Federal Open Market Committee (FOMC) chose to cut the target range for the federal funds rate by half a point, much to the delight of the market . .

After an aggressive rate hike campaign in recent years, the market has been waiting for the Fed to taper, a scenario that typically favors stocks. This could explain why the stock market has been hitting new highs all year. But while investors were pleased, the Fed’s jumbo rate cut comes with a big risk. Let’s take a look.

The rekindling of inflation

The Fed’s dual mandate includes controlling prices (inflation) and maintaining labor market stability. In the past few years, unemployment has been at historic lows, while inflation has hit a four-decade high at one point. The Fed has embarked on an aggressive rate-hiking campaign to control inflation and moderate the overheated economy.

So far, the Fed has done a pretty good job, bringing the headline inflation number down to 2.5% in August, trending toward the Fed’s 2% target, while unemployment rose to 4.2%. The Fed is trying to create a soft landing where inflation falls and high interest rates don’t send the economy into a recession.

However, the 50-basis-point cut reflects the Fed’s decision to turn its attention to the labor market amid concerns that unemployment could start to rise more than the Fed would like. Recently, the three-year monthly unemployment average rose more than 0.5 percent above the low three-month unemployment average over the past year — triggering the “Sahm ​​rule,” which has a good history of signaling a recession.

On the one hand, it makes sense for the Fed to focus on the labor market. But on the other hand, the risk is that the Fed may have cut rates too early, which could reignite inflation.

In his news conference after the FOMC’s rate cut, Powell acknowledged that the committee is not declaring victory over inflation and said the goal is to get inflation down to 2 percent and keep it there for “a while.” Despite rising unemployment, it’s hard to say the economy is in a bad place. US retail sales in August rose 0.1% from July, beating expectations. Meanwhile, shelter costs, such as housing, have risen by 40 basis points per month for virtually the entire year. In August, shelter prices rose 50 basis points from July.

Rate cuts are meant to stimulate the economy. So what if a 50 basis point high does just that? Lower interest rates can increase loan demand because the cost of debt is lower. Housing inventory also remains tight as many hang on to homes they purchased during the pandemic at interest rates below 3%. Many experts believe that mortgage rates would need to drop further for this cohort of buyers to be interested in selling, which would eventually add some supply to the housing market.

While many agreed with the decision to cut interest rates, not everyone is convinced that inflation will continue to fall. “I would say the worst outcome is stagflation – recession, higher inflation… I wouldn’t take it off the table,” JPMorgan Chase CEO Jamie Dimon said at a recent conference.

The Fed still has a difficult task

The Fed is trying to maintain a soft landing, which historically has proven to be very difficult because the very thing needed to reduce inflation (higher interest rates) usually ends up with a deteriorating labor market and a recession.

That’s why I initially thought the Fed would only do a quarter-point hike — because they haven’t won the war on inflation yet. The Fed is full of much brighter people than I, and they’ve done a good job so far with this difficult balancing act, but I think investors should be aware of the risk that comes with this half-point hike.

If inflation rises, there could be far fewer rate cuts than the market currently expects. However unlikely, if inflation were to reverse course and rise again, the Fed might even have to raise rates again. And I don’t think the market would be too happy about that.