Goldman Asks: ‘Why Cut?’

It probably shouldn’t surprise you to learn that Goldman was out Monday morning with something called “Why Cut?” from the desk of Jan Hatzius.

The bank was among the last to throw in the towel and adopt rate cuts as the base case headed into the July meeting and Goldman clung to the idea of four hikes in 2019 for longer than they probably should have last year as market conditions continued to deteriorate.

Considering how dramatic the dovish pivot from Jerome Powell and co. has been in 2019 and how aggressive markets have been about pricing in easing, it’s easy to joke about Goldman’s reluctance to accept the likelihood of Fed cuts. The irony, though, is that the whole concept of “insurance” cuts in the current environment has itself become something of a standing joke.

That is, “insurance” against what, exactly? Both the three-month and six-month averages for NFP are back above 170k after the June blowout, and although you could easily make the case for a manufacturing slowdown, there’s little in the way of evidence to support the notion that the US economy is close to careening off a cliff. Sure, you can always find evidence to support the idea that things are “cracking” or that it’s “worse below the hood”, but the critical observers among you may have noticed that it’s often the same people who spend their days searching for evidence of a recession who simultaneously joke about the inherent absurdity of cutting rates at the current juncture. See the inconsistency there?

For Goldman’s Hatzius, the only real rationale for cutting rates is that disappointing the market risks tightening financial conditions, which, in a testament to the circular, self-referential character of things, could end up making a stronger case for cuts after the fact.

As I’ve been over on countless occasions, when the market starts leaning hard into rate cut bets, it is dangerous for central banks to disappoint those expectations. That is most assuredly an example of the tail wagging the dog, but that doesn’t necessarily mean the dog is happy about the situation. That is, contrary to what you might be inclined to believe if you spent your time perusing conspiratorial blogs, the main argument for not disappointing lopsided market expectations if you’re a central banker is not that you want to inflate stock market bubbles. Rather, the argument for not blindsiding markets is that doing so risks triggering a messy unwind of crowded bets, a scenario which, depending on the setup, could tighten financial conditions (e.g., via a reversal of the “wealth effect” as stocks fall or through wider credit spreads). When financial conditions tighten significantly, it makes the case for easier monetary policy, which means disappointing initial market expectations could end up creating a scenario where what would have been preemptive easing turns into a reactive cut later. That isn’t desirable, as it suggests policymakers were behind the curve.

Is that an absurd scenario? Sure it is. But point me to a way out of it that isn’t fraught with peril. Go ahead, I’ll wait.

In any case, in “Why Cut?”, Goldman’s Hatzius notes the NFP averages mentioned above and reminds you that “if participation remains broadly stable, in line with the trend of the past five years, unemployment should soon start to edge down again”.

On the manufacturing slump, Goldman writes that in their view, “much of the recent weakness reflects the ongoing inventory adjustment” which the bank sees lopping some 1.7pp off Q2 growth. “We are now probably near the end of this process, as the level of inventory investment seems to have fallen to a below-trend pace and the economy-wide inventory/sales ratio appears to be peaking”, Hatzius writes, adding that as long as final demand remains some semblance of stable, a rebound in orders and employment should materialize “before too long”.

How about inflation? Isn’t “subdued inflation” the go-to excuse if you want to justify an insurance cut? The answer is while you can surely lean on that if you’re Powell and the Fed, the May press conference (i.e., the “transitory” presser) was proof that you can just as easily spin the opposite narrative if you want to walk back market expectations. Here’s Hatzius on that point:

Chair Powell’s May 1 FOMC press conference, in which he characterized the weakness as ‘transient’ and emphasized the stability at 2% in the Dallas Fed’s trimmed-mean index, still looks like the right take on the issue. In fact, both the core PCE and the trimmed-mean PCE remain at the same year-on-year levels as two months ago, and each has risen at sequential rates of more than 2% since then. Wages likewise look consistent with inflation near the target, as our wage tracker has moved back up to 3% in Q2. So we continue to expect core PCE inflation to return to 2%+ in early 2020. 

Why, given all of that, does Goldman still expect a 25bp cut in July and September? The answer is simple: Because the market demands it and disappointing the market could end up leading to tighter financial conditions, which would eventually argue for a cut anyway.

“Whether or not this is ‘justified’ by the fundamentals, it probably matters for the near-term monetary policy outlook because it raises the cost of doing nothing”, Goldman goes on to write, before reminding you that on their estimates, “failing to deliver 50bp of cuts could tighten our FCI by 50bp, via a combination of higher bond yields, lower stock prices, wider credit spreads, and a stronger dollar”.

So, yes, the tail is wagging the dog. But not in exactly the same kind of way that’s conducive to wholly simplistic takes on the market-Fed nexus.

Again, the concern isn’t so much that “spoiled” traders and investors will be mad if stocks fall, it’s that the combination of falling stocks, widening credit spreads, rising long-term bond yields and a stronger dollar have the potential to affect the real economy, at which point the rate cut you chose to forgo in an effort to “prove a point” to markets, would become necessary a month or two down the road. That, in turn, raises this question: What’s the point in forgoing it in the first place?

Of course, taken to its logical extreme, this means the Fed would always be cutting rates in a never-ending, recursive quest to head off things that haven’t happened yet.

What’s the “right” answer? Nobody knows. But what we do know for sure is that this is the kind of thing that should be discussed in a serious way, rather than confined to snarky blog posts and daily columns penned by people who, by virtue of not having the weight of the entire financial universe resting squarely on their shoulders, are free to poke fun at PhD economists and public servants without any accountability.