Why The Fed May Not Be Able To Cut Rates, According To Goldman

The concept of “insurance cuts” is all the rage these days as traders and analysts work to conceptualize rate cuts when unemployment is parked at a five-decade low and the economy is still performing reasonably well (recent signs of deceleration notwithstanding).

Just three months back, rate cuts seemed like an absurd proposition to everyone except Donald Trump, Stephen Moore and Larry Kudlow, all of whom loudly insisted that the MAGA mandate demanded the Powell Fed atone for its December sins.

Fast forward to the June meeting and, thanks in no small part to Trump’s insistence on ratcheting up trade tensions and thereby clouding the outlook, cuts no longer seem quite as absurd, especially when you consider that recent data suggests central banks might be on the verge of seeing inflation expectations become unanchored (on the downside, of course).

And so, the market aggressively priced in Fed easing and the 1995 parallels proliferated.

Goldman has never been wholly convinced, so it comes as no surprise that Jan Hatzius is skeptical about the “insurance cuts” narrative.

“The idea behind insurance cuts is that instead of waiting for an actual deterioration, policymakers should proactively push rates below the levels implied by the baseline outlook when the economy passes through a period of unusually elevated uncertainty–such as the renewed trade conflict with China– in order to ‘buy insurance’ against an unfavorable outcome”, Hatzius wrote Sunday, adding that “the cumulative 75bp moves of 1995-96 and 1998 are seen as historical precedents of insurance cuts.”

The problem, he says, is that the bar for these kinds of rate cuts is higher than the market believes and even if it wasn’t, political considerations matter. Here’s Hatzius on the would-be historical analogs:

The 1995-96 and 1998 cuts were not just insurance. In 1995, the real funds rate was at a highly restrictive level (as Fed officials recognized in real time) and the economy had slowed sharply; in other words, policy looked clearly too tight. In 1998, financial conditions had tightened by 100bp within six weeks and market functioning had deteriorated meaningfully in the wake of the Russian default and LTCM failure. In both cases, the case for Fed easing therefore rested at least as much on observable deterioration as on an insurance motive. 

He goes into more detail in the full note, but you get the point.

More interesting, though, is Goldman’s take on the nexus between the Fed and the Trump administration.

“A key assumption underlying the case for insurance cuts is that they can easily be reversed if the risks don’t come to pass [and] indeed, the Greenspan Fed hiked rates 25bp in March 1997 and reversed the late-1998 insurance cuts starting in June 1999”, Hatzius says, before delivering the following assessment of the current situation:

Such a quick reversal looks harder now. There is little doubt that President Trump and his allies would be highly critical of any Fed rate hikes in the remainder of his term, and especially in 2020. Although the Fed is independent, this scrutiny probably raises the hurdle for how clear-cut the case for renewed hikes needs to be before they happen.

Once again, Trump’s incessant badgering of the Fed may have created a situation where Powell is hamstrung in his capacity to protect the economy (and stocks) because doing so risks charges of politicization. That might not be the case had the president and his advisors not opined so publicly on the matter.

Hatzius takes it a step further, noting that if the Fed did cut, trade tensions abated (possibly because Trump executed on his “crazy like a fox” plan by calling off the tariffs after securing the rate cuts he wants) and the economy held up, hiking rates would be impossible because by that time, it would be an election year.

“Before delivering any insurance cuts, Fed officials will therefore want to assess the risk of finding themselves in a scenario in which the economy continues to hold up well… and it becomes clear that a sub-2% funds rate is simply too low”, Goldman remarks. “If so, the committee would face the unpleasant choice of either keeping policy too easy or attracting a great deal of criticism for hiking rates in the run-up to a presidential election.”

Of course, that likely isn’t lost on Trump. In the event the Fed hiked rates in an election year in an effort to reverse the insurance cuts once things settled down, Trump would doubtlessly blame any blip in the economy on those hikes. It is not at all far-fetched to suggest he might attempt to keep the trade tensions simmering in order to buy himself some insurance against any Fed hikes aimed at rolling back their insurance.

All of this underscores the risk of crossing what Deutsche Bank this month called “the political event horizon”. As the bank’s Aleksandar Kocic wrote, it’s possible that the Fed gets “dragged into becoming a permanent part of the policy mix with all the implications that role entails.”

Read more:  Powell Fed Faces ‘Political Event Horizon’ — And Crossing It May Mean No Way Back

In any case, the market is convinced the Fed has no choice. It’ll be interesting see if traders, like Trump, try to box Powell in even further.

“Given how far we’ve come, it would be surprising for the market to go on pricing in more and more until we see either further signs of economic weakness or get a clear steer from the Fed”, SocGen’s Kit Juckes wrote Monday. “If all the central bank is doing is using the absence of inflation to buy some insurance against slowdown, it is unlikely to deliver as much as the market expects.”