Why The Fed's First Rate Cut Wouldn't Be That Big Of A Deal

Stocks fell last week, with the S&P 500 shedding 0.8% to end at 5,459.10. The index is now up 14.4% year to date and up 52.6% from its October 12, 2022 closing low of 3,577.03.

The calls for the Federal Reserve to begin cutting interest rates sooner than later have been getting louder.

The resistance to these calls seems to be the suggestion that an initial rate cut would represent some monumental dovish shift in monetary policy at a time when concerns about inflation haven’t been fully put to rest.

But it’s not obvious to me that one rate cut is so big of a deal that it warrants some extraordinarily high hurdle for it to happen, especially with economic activity trends cooling.

‘Get On With It’

Inflation metrics have been coming down for two years and are now at levels that are just a rounding error away from the Fed’s 2% target rate.

Meanwhile, economic activity growth has been decelerating significantly, with labor market metrics normalizing. The economy has been looking a lot less “coiled” with many signs of excess demand fading.

“Previously, with inflation far from its objective and employment closer to its objective, the Fed's focus was on inflation” BofA’s Michael Gapen said on Thursday. “Now, with smaller deviations in inflation and employment from target, the Fed's attention can be more balanced. Cuts can happen because the economy cools, because inflation slows, or both.“

The Fed’s preferred measure of inflation is down significantly from crisis levels. (Source - BEA via FRED)

The risk of recession has been rising with economic growth slowing. Consumer spending growth plateauing and debt delinquencies rising are among the emerging warning signs. Notably, the unemployment rate has been ticking higher.

Taken altogether, it’s not surprising to hear Fed watchers argue for a rate cut.

“Get on with it” says Renaissance Macro’s Neil Dutta, who has been out front among his peers with this call.

The Fed’s Federal Open Market Committee (FOMC) meets for its monetary policy meeting this coming Tuesday and Wednesday. While it’s unlikely that the central bank will announce a rate cut at the conclusion of this meeting, it may use it to signal future changes in policy.

“The Fed is getting closer to begin recalibrating monetary policy” Dutta wrote in a note to clients on Monday. “Recent commentary strongly point to a September rate cut with July’s meeting being used to prep the markets that a series of cuts are on the horizon.”

Dutta isn’t alone in his call for the Fed to begin cutting rates soon.

“Markets are almost fully priced for a cut at the September 17-18 FOMC meeting, which remains our baseline forecast” Goldman Sachs’ Jan Hatzius said earlier this month. “But we see a solid rationale for cutting as early as the July 30-31 meeting.“

Even former NY Fed President and longtime hawk Bill Dudley has made the case for a July rate cut.

“The Fed should cut, preferably at next week’s policy-making meeting” Dudley wrote on Wednesday. “Although it might already be too late to fend off a recession by cutting rates, dawdling now unnecessarily increases the risk.“

While he hasn’t explicitly said anything about cutting rates in the coming months, Fed Chair Jerome Powell has recently acknowledged the growing risks to the economy.

“[I]n light of the progress made both in lowering inflation and in cooling the labor market over the past two years, elevated inflation is not the only risk we face” Powell said in his testimony to Congress earlier this month. “Reducing policy restraint too late or too little could unduly weaken economic activity and employment.“

Monetary Policy Is Not A Light Switch

While a first rate cut is arguably a historic milestone in the Fed’s fight to end the inflation crisis, I’m not convinced it’s as explosive of a market event as some pundits imply.

“I don’t think monetary policy is a ‘light switch’” Dutta explained on CNBC. “It’s not on or off. The Fed can be nimble and flexible.”

I like this characterization because it addresses a nuance ignored in many discussions about rate cuts.

And I’ll take Dutta’s analogy a step further and say monetary policy is a “dimmer switch.” If your lights are on full power and you dim them by 5%, they’re still pretty bright, right?

Now take the Fed’s 5.25% to 5.5% target range for rates and cut it by 25 basis points. You get a range of 5% to 5.25%. Sure, that would mean monetary policy is a little less tight. But it certainly can’t be characterized as loose monetary policy.

A 25-basis-point rate cut today is not that big of a deal. (Source - FRED)

With inflation mostly under control and economic data deteriorating, what’s the harm in dimming monetary policy a little? There’s arguably more upside than downside.

Frankly, I think all the concerns about a first rate cut are overblown. As I argued in the January 28, TKer:

First of all, we’re talking about a potential 25-basis-point cut from a range of 5.25% to 5.5%. Sure, that’s not insignificant. But that’s nowhere near as big a deal as it was when we were talking about 25-, 50-, and 75-basis-point rate hikes from near 0%.

Second, all those big rate hikes early in the hike cycle were happening amid an intensifying inflation crisis. The economy was a complicated mess in 2022. Today, that crisis is largely behind us with inflation rates hovering near the Fed’s target levels…

In other words, the stakes for the upcoming Fed policy meetings aren’t nearly as high as they were in 2022 and 2023.

In March 2020, when the Fed cut rates by 150 basis points to effectively 0% as the economy was falling apart, that was a big deal.

Compared to monetary policy actions during more troubled times, cutting by just 25 basis points today just doesn’t seem like that big a deal.

Keeping historical context in mind, it may be advisable for the Fed to explicitly downplay the significance of a single rate cut and manage expectations for what a cut means for policy down the road.

“[W]e think Powell should and will avoid describing the first rate cut as consequential, as this conveys a sense of a series of rate cuts coming, which is the opposite of data dependent” JPMorgan’s Michael Feroli wrote on Friday.

One rate cut may or may not bolster growth a little. It may or may not cause inflation to tick up a little. Who knows? But it’s hard to imagine a single rate cut going down in history as some massive policy blunder.

Zooming Out

Maybe it’s the inevitable expectation that a first rate cut means that many more rate cuts are coming, and that’s what eventually moves inflation and other metrics in unfavorable ways. Well, then maybe the Fed will reverse course after the initial rate cut. As Dutta says, monetary policy is not a light switch, and the Fed has room to be nimble.

As far as the outlook for the stock market is concerned, history shows mixed results after an initial rate. Though, the 12-month price performance is less favorable when the Fed is cutting into a recession.

If the economy were to hold up following a first rate cut, then history suggests the outlook for stocks is positive.

A first rate cut may be followed by further stock market gains if the U.S. economy stays out of recession. (Source - Callie Cox)

“It doesn’t look like we’re in a recession — or even close to one” Cox wrote. “If history proves correct, we could see the stock market continue to move higher in a slow, grinding fashion.”

What the Fed does or doesn’t do in its upcoming policy meetings is sure to come with some kind of a market reaction. This can be said about most developments in the markets.

However, a 25-basis-point cut from a range of 5.25% to 5.5% seems pretty inconsequential relative to many of history’s other rate adjustments. And it would be a cut that comes as economic and financial market activity is relatively healthy.