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The Fed will pause not pivot

Ever since the 1987 stock market crash the Fed has cut rates at almost the first sign of an economic downturn. They did it in 1990, 2001, 2007, 2019 and 2020. But on all those occasions inflation was well-behaved so they had no reason to delay. Before 1987 however, when inflation was a persistent problem, a weaker economy did not always bring rate cuts. Indeed, in 1974 and 1982 rates went up, when the economy was already in recession.

In this cycle, rates are set to rise again in September, most likely by 50bps (to 2.75-3%). The Fed will probably want to move more slowly from there, but both markets and the Fed expect further hikes, to 3.5% at least. These will not be hard decisions as long as the economy is still growing and/or inflation remains high.

But sometime in the next few months the Fed will have a difficult decision to make. The Jackson Hole central bankers meeting this week may shed some more light on Fed thinking. For now I expect Chairman Powell to continue to try to sound both hawkish and data dependent. But it will be interesting to hear what he has to say, if anything, about the end of the rate hike cycle when things will get more difficult.

The tough decision

Headline inflation should be clearly coming down later this year and into next. But core inflation and wages might not be behaving so well. What will the Fed do if it is faced with what looks like the beginning of a mild recession yet core inflation is running at 3-4% or more and wage growth is still running hot? If the Federal Funds rate had reached 3.5% then, real rates would be flat, not positive. In other words it would not be overwhelmingly clear that the Fed was being too restrictive.

My guess is that the Fed will want to pause at that point, to watch the data, not quickly pivot to cutting. If the economy really tanks with unemployment rising fast and/or if wages and core inflation appear to be slowing rapidly, then yes, a pivot would be in order. But if the recession appears mild, stock markets have not slumped and core inflation looks to be coming down sluggishly if at all, then the Fed will stay on hold. Potentially for a long time – months or even years rather than weeks.

It is true that wages and inflation lag the cycle. So, at some point, given an economic slowdown that is deep and/or long enough, wages will soften too. This is another reason why the Fed has often cut early in a recession when inflation is more of a potential threat than a current problem. But this time inflation is way too high. It would be risky to cut rates too quickly, in anticipation that inflation will fall. The Fed made that mistake in 1970 (see below). The Fed will want to be sure this time.

Back to the 70’s?

In response to the 1970 recession the Fed quickly cut rates but that was soon seen as a mistake as inflation did not decline as expected. So in 1974, the Fed raised rates in the middle of a recession, because inflation was again persistent. And this was before Paul Volcker became Chairman by the way. Under Volcker it also raised rates in 1980 and 1982, again during recessions. The point is that a Fed determined to defeat inflation may hang tough. That’s why data dependence will be key. My guess is that a mild and shallow recession (as I expect) will be enough to put the Fed on hold, but not to slash rates. Not until core inflation is back near 2% or unemployment has risen so high (well above 5%) that further falls in core inflation are clearly in the bag.

No Fed put for the stock market

Finally, it is worth emphasising that the Fed’s ‘put’ for the stock market is gone for now, unless we see extremely disorderly conditions. It was notable in the Minutes of the July meeting, released last week, that FOMC members expressed satisfaction that valuations were down, because of the better outlook for financial stability, rather than concern that a weak stock market would badly impact the economy. In fact of course, a weaker stock market is part of the tightening of financial conditions they are trying to achieve. In that respect they are likely to be concerned about the recent rally rather than in any way relieved. Investors beware!


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