As expected, the Fed cut rates today. Most market participants seem to think this is a good idea (or that they should have done more). I am not one of them. If the rationale is truly concern over a slowing economy largely driven by trade issues, then the Fed really got this wrong.
The simple mistake is overlooking that trade disruptions are supply shocks, not demand shocks. More on this a bit below. But to start, let’s review how a bad trade war would impact the economic outlook.
The Mechanics of a Trade War
Two things happen in a trade war. First, production gets shifted to higher cost providers which is negative for global GDP. Second, goods get more expensive because of the tariffs, so prices go up.
Ironically, a big part of the Fed’s rationale on why it is “safe” to cut is that inflation is quiescent so they can take an insurance cut. I say ironic because if there is no sign of impending inflation, then there is no sign that the trade war is having a harmful effect. Thus, there is no reason to cut rates to support the economy.
However, let’s say that the Fed is right to be worried about the trade impact and a recession is imminent. This would mean that inflation is about to accelerate and they are playing a dangerous game. Frankly, if we want to talk about “insurance” cuts, the Fed could let employment slide a bit from record levels to protect against inflation. After all, the consumer is doing great and is much better prepared for a downturn than in recent recessions. It wouldn’t be a crime if we “only” had a 4.0-4.5% unemployment rate.
The real sin could be overstimulating an economy that is at risk of stagflation. Yes, stagflation. Let’s go back to the idea of supply shocks. Recall your basic supply and demand curves from econ 101.
Tariffs Are a Supply Shock
If the input of a product gets more expensive (e.g. from tariffs on components), a producer will either charge more to make the same amount or, if they can’t raise price, they will produce less. This is a supply shock. The supply curve moves up and to the left. Meanwhile, end product tariffs mean consumers will respond to the higher prices by buying less. That means they move along the demand curve up and to the left.
The result of a supply shock is prices go up and output (aka GDP) is lower. This is stagflation from the 70s. A trade war really isn’t any different than an oil embargo. The magnitude is clearly less but the underlying principles are the same.
Why does this matter? Because the Fed has a lot less ability to counter supply shocks than demand shocks. Negative supply shocks need to be countered with positive supply shocks, aka “supply side economics” aka Reagonomics.
When the Fed tries to counter a supply shock, they are left with one of two bad choices. Cut rates to help GDP but add more inflation OR raise rates to curb inflation but cause a painful recession.
If we are really facing a bad trade war, the Fed cutting is compounding the inflationary impact in order to moderate the economic impact. This might be good in the short term, but there is obviously a long term cost. Taken to its extreme, we end up in the late 70s wearing WIN buttons.
And the Fed Is Built for Demand Shocks
There is one other important consideration for the Fed. All the new “tools” developed over the last 10+ years have been about countering demand shocks. Negative interest rates, quantitative easing, etc. were all designed to counter negative demand shocks. If the Fed cuts rates towards zero unnecessarily and we later face an actual supply shock created recession, the QE toolbox will no longer work.
QE will counter the GDP drag but adds more inflation to a stagflationary environment. The institutional knowledge of how to fight supply side shocks has been lost as a new generation of Fed leaders have been focused solely on how to stimulate demand in a world post a financial crisis. If they erringly resort to buying corporate bonds, they are going to create a whole host of problems.
A Better Course of Action
The only semi-legit reason to cut rates today is because our rates are high vs. the rest of the world which has caused the curve to flatten. Of course, the Fed will never admit this is a concern, as it is not part of their mandate to focus only on inflation and employment.
There is some risk to the economy from rates that are too high relative to alternatives, but this should really be regulated by the trading price of the $ relative to other currencies rather than something that requires Fed intervention.
Yes, inverted curves are a warning sign of impending recession, but they are not a guarantee. Also, when we live in a world where every major central bank is manipulating markets, it is hard to know what the unaffected yield curve would look like if markets were allowed to function naturally.
The best bet for the Fed would have been to sit back and watch. Let more data come in and then respond rather than doing something to create the appearance of action. Often, the best course is to do nothing. In investing lingo, the Fed is over-trading its book.