
If the Fed decided to lower its interest rates, we could well see a meteoric takeoff in the markets. Money would flow freely and certain financial assets like bitcoin (BTC) could reach unprecedented heights.
The Fed has achieved a feat
At this point, there is no doubt that the American economy made a soft landing.
Even with an incredibly low unemployment rate of 3.7%employment figures continue to soar: payrolls increased by more than 350,000 in January, beating expectations, and previous figures were revised upwards.
And all this is happening while wages are increasing and inflation has fallen to the 2% target.
This is a feat. Very few people thought the Fed would be able to curb post-pandemic inflation without throwing large numbers of people out of work, but somehow she managed it.
Will the Fed cut rates?
The next big question is: will the Fed cut rates this year?
Great fortunes could depend on this decision, as could the short-term fate of the American economy. But the answer is surprisingly vague. Jerome Powell recently downplayed the likelihood of a decline in March.
Jerome Powell delivered a clear message to traders eager to see the central bank start cutting interest rates. Powell vigorously rebuffed hopes of first action at the next meeting in March, saying it is unlikely to act so quickly as it awaits further signs that inflation is steadily moving closer to its target.
The obvious reason not to cut rates soon is that the economy is doing so well.
The standard intuition is that when everyone has a job and wages rise, people buy more products, which ultimately puts upward pressure on prices.
Additionally, there is the general intuition that “if it ain’t broke, don’t fix it.” If interest rates of 5.3% have not harmed the real economy so far and if they succeeded in bringing inflation back to its target level, why make waves by returning to low interest rates?
That being said, it is likely that the Fed is starting to cut rates quite quickly, if not in March, but within the next three months.
Interest rate cuts likely
There are basically three reasons for this.
First, and most optimistically, we have what appears to be an acceleration in productivity growth.
The simplest measure of short-term productivity growth is labor productivity, that is, total economic output per hour worked, adjusted for inflation.
It is very positive to see labor productivity increase when the economy is booming. These are real improvements thanks to technological applications, better economic models…
Rapid productivity growth allows the Fed to cut interest rates.
The reason is quite simple: productivity growth is a inherently deflationary force. It means that more things are produced, which tends to lower prices.
The Fed can counter this trend by reducing interest rates, which puts positive pressure on prices and thus maintains price stability.
In other words, rapid productivity growth constitutes a positive shock to aggregate supply. The Fed must ensure that aggregate demand increases at the same rate as aggregate supply, in order to keep the economy balanced.
The way to increase the growth rate of aggregate demand is to reduce interest rates.
Towards a major financial risk?
Reducing inflation without damaging the real economy was an incredible feat. But this success could be called into question if keeping rates high for too long caused a financial crisis and recession.
Many observers believe that the greatest danger to the real economy is the commercial real estate sector. Office buildings are already losing part of their value due to the rise of remote work.
This situation puts many businesses at risk: developers who construct and renovate buildings, rental companies, companies that own their own office buildings, etc.
High interest rates are a double whammy for many of these businesses. Real estate companies tend to be highly leveraged – when they have to pay much higher borrowing costs, they tend to go bankrupt.
Many of these companies issued their bonds when rates were low, before 2022, so they are not at risk for now since they are still paying these low rates. But the higher rates remain, the more that debt must be rolled over at a newer, higher rate.
So the higher the Fed keeps rates, the more real estate companies will go bankrupt.
From a real estate crisis to the banking crisis
The real danger is that a wave of defaults by moribund real estate companies harms the banking system, leading to damage to the real economy – basically a more modest version of 2008.
Banks tend to lend a lot to real estate companies, they are therefore very exposed. Already, the commercial real estate sector is causing major headaches for some banks.
Regional lenders, in particular, are more exposed to the sector and likely to be hit harder than their domestic banking counterparts. Commercial real estate loans represent 28.7% of smaller banks’ assets, compared to just 6.5% for larger lenders.
The higher the Fed keeps rates high, the greater the risk of a financial crisis in which a large number of small and medium-sized U.S. regional banks fail.
Unlike last year, when the government guaranteed the deposits of struggling medium-sized banks and thus averted a crisis, the only way to save small banks in the event of a wave of commercial property defaults would be to carry out large-scale bailouts, as in 2009-10.
But even that would probably not be enough to protect the real economy from a recession, as previous experiments have shown.
If this happens, it will end the euphoria over the Fed’s successful soft landing. In fact, it will then be a question ofa hard landing.
Interest rates: prepare for the worst?
Economists will say that disinflations are never without costs – that at the end of the day, there is always a recession. Experts will debate whether the Fed should have raised rates in the first place or simply waited for inflation to disappear on its own.
But if the Fed cuts rates before most low-interest commercial real estate debt matures, businesses will be saved from death by refinancing.
Remote working can still cause some bankruptcies, but the risk of a systemic financial crisis will be significantly reduced.
Markets predict a drop in interest rates
The third big reason why the Fed should cut rates is that markets and businesses expect it to do so.
Even after Powell’s recent comments, markets expect the Fed to significantly cut rates starting in the spring:
In fact, markets expect the Fed to start cutting spending even more quickly than its own forecasts predict.
Why should this influence current Fed policy? Because part of the current economic boom may be due to these expectations of rate cuts from the Fed.
Companies may have made large investments thinking they could refinance their debt more cheaply in a year or two.
If these assumptions prove wrong – if the Fed keeps rates higher than markets expect – it could lead to the bankruptcy of a greater number of companies and, therefore, a weakness in the real economy.
We could thus transform a soft landing into a hard landing.
Policy and interest rates
There are at least two other reasons why the Fed should cut spending, and they are both of a political nature.
First of all, when interest rates remain high for a long time, the federal government must devote a much larger share of its budget to repaying interest on the national debt.
It’s already the case.
To avoid this, the Fed might want to lower interest rates, so the government can refinance the debt more cheaply.
However, for the moment, the United States does not appear to be in danger of default. Therefore, the Fed is unlikely to use low rates as a means to bail out Congress’s overspending.
Setting such a precedent would bind the Fed to Congressional spending decisions, effectively compromising the institution’s independence.
Trump’s influence on the Federal Reserve
The other political factor is Donald Trump, who appears to have a decent chance of being elected in November. Trump has repeatedly threatened the independence of the Federal Reserve.
However, the Fed is very, very attached to its independence. Some (including Trump himself) have therefore suggested that the Fed may soon cut rates in order to keep the economy healthy and maximize Mr. Biden’s chances of re-election.
The risk of a “prolonged rise in rates” is that it could lead to a deterioration in the economy as the elections approach and jeopardize Biden’s chances.
If that were to happen, he said, “former President Trump is the most likely to be elected president and will have the opportunity to truly remake the Fed in his image this time around, which could damage the credibility of the institution more than Powell would have done by lowering rates during the presidential campaign.
During the first term, Trump’s nominations of radicals such as Judy Shelton, who favored a return to the gold standard, failed in the Senate. This is much less likely to happen in a second term.
Right now Trump is shouting everywhere that Powell is going to cut interest rates with the sole aim of compromising his re-election.
All things being equal, this will encourage the Fed to be more wary of rate cuts, so as not to validate the rumor.
It’s likely the Fed will start cutting rates fairly quickly. When the risk of keeping rates high clearly outweighs the risk of cutting too soon, the decision becomes easy to make. This is becoming the case.
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