It hasn’t always been easy being Jerome Powell over the past year.
Donald Trump’s embattled Fed chair likely knew his would be an exceptional tenure, considering he was tasked with presiding over the latter stages of policy normalization. And it likely wasn’t lost on Powell that, sooner or later, he would find himself on the wrong end of a presidential tweet or two (or three).
But Powell probably didn’t foresee an emerging market meltdown unfolding during his first six months as chair, and he probably never imagined his first seven FOMC decision days would be accompanied by losses on the S&P.
(Bespoke, through the December meeting)
Of all the things Powell didn’t see coming, it’s safe to say what’s surprised him most is the brazenness of the president’s attacks on the Fed. Again, Powell surely knew he would rankle Trump at some point, but the idea of being attacked publicly on a monthly (and sometimes weekly) basis probably never occurred to him. The idea that his patriotism would be implicitly questioned by the president (during a speech to a raucous CPAC crowd), or that he would be bad-mouthed during a fundraiser at the Hamptons home of a hot dog baron, likely never occurred to him either.
Now, Powell finds himself staring down his most daunting challenge yet. The worsening trade war threatens to push the global economy into recession with likely spillover effects for the US economy, and inflation remains stubbornly subdued. That argues for preemptive rate cuts.
But, unemployment is still sitting at a five-decade nadir and the US economy is still on reasonably solid footing. At the same time, Powell most assuredly knows that early rate cuts will be seen by some on Capitol Hill (and also by markets) as the Fed bowing to political pressure.
Worse, rate cuts now could make the trade war worse by emboldening the president in his efforts to squeeze America’s trading partners. And then there’s the theory that Trump is intentionally ratcheting up the trade tensions in order to force a Fed cut, only to call off the trade war once policy has been eased.
It’s a mess, to be sure.
“The Fed is conflicted. Data is not bad enough to warrant rate cuts. However, given the underlying risks (which haven’t become visible in the data yet), it is dangerous for the Fed to remain on the sidelines”, Deutsche Bank’s Aleksandar Kocic wrote, in a note dated Friday.
In addition to risking a perceived loss of independence, preemptive rate cuts also perpetuate the Fed’s addition liability. “While it is generally beneficial for the markets to have a preemptive rather than reactive Fed, in the absence of other supporting factors, rate cuts become addictive and create conditions of dependency from which it might be impossible to get out”, Kocic went on to say.
As if this calculus needed to be any more complicated, 2020 is an election year, and the curve has already inverted. Trump supporters who understand that curve inversions generally precede recessions (and that’s probably a small group), will invariably argue that Powell is conspiring against the president – that the Fed is part of the “deep state”.
“We can look at writings and speeches of numerous past Federal Reserve Board members to know that the current board does not support the President’s trade policies”, one reader said Sunday, before positing a conspiracy. “I believe I am not exaggerating that the FRB has created the flattened yield curve to restrict the President’s ability to carry on his trade policies”, this person said.
If he understood it, the president would doubtlessly agree, and this kind of conspiratorial thinking makes Powell’s job that much harder. If he cuts rates, he’ll be accused of politicizing the Fed by pandering to Trump. If he doesn’t cut rates, he’ll be accused of the same thing (politicizing monetary policy) only in the service of undermining the president’s agenda. In one case, he’s compromising the integrity of what, at the end of the day, is arguably the most important institution in the world. In the other case, he’s a traitor to his country.
“An additional layer of difficulty associated with preemptive cuts, before allowing time for tariffs to make an impact on the economy, is that the Fed would be stepping outside of its traditional mandate and becoming a part of the policy mix and, as such, possibly compromising its independence”, Deutsche’s Kocic went on to say, in the same note cited above.
Next, he remarks that the curve is pricing in “considerably” more negativity than other assets. Consider the following in that regard:
At the end of the internet bubble, the inversion of the forward curve was roughly at the same level as it is currently. Between Jan and Jun 2001, Fed delivered 250bp worth or rate cuts in the subsequent 6M period. However, the stock market started its decline before rate cuts: between Aug and Dec 2000, S&P declined 18% from its peak and another 15% Jan-Mar 2001, before the first turnaround. This is a 36% decline peak to trough. In 2007, the rates market was pricing almost twice as many cuts as it is today. The Fed delivered 175bp in the first 6M. During that period, between Sep-2007 and Mar-2008, equities declined by 22%. For comparison, the current decline in S&P has been only 4% from its highs, although the rates market is pricing in more than two rate cuts.
The only way out of this for Powell is if the domestic economy rolls over in earnest, rendering debates about the politicization of the Fed irrelevant. But that kind of weakness will take time to develop, and market pricing suggests anything short of cuts starting in July will be seen as a hawkish surprise.
So, Powell has to choose.
“When discussing the risk/reward of preemptive cuts versus restraint, the comparison should be made between the Fed doing nothing and risking that political negotiation process triggers a recession, or that the Fed could get dragged into becoming a permanent part of the policy mix with all the implications that role entails”, Kocic goes on to say.
If that latter option sounds precarious, that’s because it is. Indeed, Kocic’s use of the word “permanent” when describing the possibility that the Fed gets roped into the policy process suggests there may be no way back for the Fed, just as there was no way back after 2008 when the central bank stepped in to rescue markets from the abyss. The Fed has been subsidizing things since.
“The current possibility of crossing the political event horizon is associated with a potential loss of Fed independence, a sign of contamination with political entropy and, as such, a loss of informational content and transparency”, Kocic warns. “After all, entropy is a measure of disorder and the missing information”.