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Now is not the time to cut interest rates
THE latest statement by the Fed all but confirmed an upcoming rate cut in the months ahead. While the dovish U-turn made by Fed chairman Jerome Powell since December has definitely brought relief to the market, the fact is that the data-driven Fed of 2018 has been replaced by a market-driven Fed today. This is because the economic indicators are still relatively strong, but the drumbeat of preventing another market meltdown like the one in the final quarter of 2018 has grown louder.
The narrative goes like this: the Fed raised interest rates four times in 2018, the last one amid heightened trade tensions between the US and China, and this has caused the stock market to fall by more than 20 per cent. Some market indicators, especially the spread between the three-month interest rate and the 10-year Treasury note yield, have also gone negative - indicating that the market is expecting deflation in the future to compensate for lower long-term returns. Since the market represents the collective wisdom of all investors, their prognosis of the state of the economy must not be too far off.
In the past, such a market prediction would have been corroborated by weak economic indicators. This time, however, economic indicators have remained strong.
Let's begin with business sentiment. The Institute for Supply Management (ISM) index for manufacturing recorded 52.1 in May, indicating that manufacturers remain positive (a reading above 50 indicates positive sentiment while one below 50 reflects bearishness). While that certainly is a drop from the 60.8-high in August 2018, it is nowhere close to the low of 40.8 after the Dotcom bust in 2000 and 34.5 after the global financial crisis in 2008. In fact, over the last 20 years, the August 2018-high of 60.8 was topped only by a 61.4 print in May 2004. Such bullish business sentiment was simply not sustainable. It came down by its own weight and, of course, pulled by the US-China trade spat.
Consumer confidence has also remained elevated. The Conference Board consumer confidence index in May was 134.1, a tad lower than the recent high of 137.9 in October 2018, but a huge improvement from the low of 24.3 in February 2009. The highest it has reached in the past 30 years was 144.7 in May 2000. Consumer confidence has been supported largely by the strong labour market and high home prices. The 3.6 per cent unemployment rate in May is the lowest in almost 50 years, and the seasonally adjusted Case-Shiller home price index for the largest 20 cities in the US is at the highest level since the index was constructed in January 2000. At 215.3 in March, it is even higher than the 206.7 reached at the peak of the housing bubble in April 2006.
Sentiment among home builders is also firm. The National Association of Home Builders index, which measures the confidence of home builders, was 64 in June. Although it is lower than the 74 printed in December 2017, it is far better than the 8 posted in January 2009. Like the ISM, it simply came down by its own weight.
The one economic indicator that the Fed has relied on to warrant an interest rate cut is low inflation. Headline consumer price index (CPI) inflation, which takes into account energy and food prices, has dropped to 1.8 per cent on a year-on-year basis compared to about 3 per cent in July 2018. But the decline can be attributed largely to the fall in oil prices. Over the same period, the West Texas Intermediate (WTI) crude oil price has fallen from around US$75 per barrel to a low of around US$50 per barrel. Core CPI inflation, which excludes energy and food prices, rose 2 per cent on a year-on-year basis in May, consistent with the Fed's target.
While low oil prices have brought headline inflation below the Fed's 2 per cent target, it is well accepted that low oil prices act like tax subsidies. That is, they put more spending power into consumers' pockets. Hence, low oil prices may hurt big oil companies that are represented in the stock market but it is a boon for consumption that accounts for more than 70 per cent of the US gross domestic product.
Clearly, from an economic perspective, there are no grounds for the Fed to cut interest rates in the near future. The only reason for it to do so is to preempt any fall-out from the US-China trade conflict. While trade was not explicitly mentioned in the Fed's June Federal Open Market Committee communique, it is quite clear what the elephant in the room is. With supply chains as integrated as they are today, tariffs on a China producer would have dramatic negative spillover effects on the US economy. Mr Trump's mercurial attitude only throws more uncertainty into the mix.
However, any notion that looser monetary policy could solve the problems caused by a trade war is fundamentally flawed. Monetary stimulus is only effective in solving monetary problems. While it may provide a sugar-rush for the market, it cannot prevent an economic meltdown if the trade conflict turns into a full-blown trade war.
Cutting interest rates right now would be like throwing good money after bad. Worse, it could lead to some undesirable consequences for the Fed.
Firstly, it would further solidify the market's expectations of a "Powell Put" - the Fed would always bail out the market with additional stimulus should prices look like they are heading south. This would result in moral hazard problems that would dramatically increase risk-taking and reduce the effectiveness of the Fed's monetary policy. It would also expose the economy to systemic risks like during the Great Financial Crisis.
Secondly, it could harm the perception that the Fed is independent of the government. Should the Fed cut interest rates in response to political pressure, it could dramatically undermine the Fed's credibility and even hurt the US dollar's status as a global reserve currency.
Finally, a rate cut now would shrink the room the Fed has to cut interest rates in the next recession. This would require the Fed to resort to unconventional measures again, probably with drastically reduced effectiveness.
The state of the US economy clearly does not warrant an interest rate cut by the Fed. Preempting a potential fall-out from the US-China trade conflict not only assumes the worst, but could also be viewed as politically motivated.
While the proverbial Rubicon has been crossed with the Fed's latest rhetoric, it should carefully weigh the consequences of disappointing a financial market addicted to liquidity and losing its most valuable asset - its credibility.
- The writer is associate professor of Banking & Finance at Nanyang Business School at NTU Singapore. This commentary is written with his assistant Gregory Lee.