The case for a Fed rate cut

The case for a Fed rate cut
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Monetary policy works with long and variable lags, and the Fed has been tightening for a while now. This is one key reason why we project real GDP growth to slow meaningfully this year compared to last.

In order to keep the economic expansion intact, the Fed will need to take back some of its recent tightening, which looks increasingly unnecessary. If so, the Fed should be able to pull off a soft landing, similar to what policymakers did after the 1983-1984 and 1994-1995 tightening episodes.

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In essence, the Federal Open Market Committee (FOMC) has raised interest rates much more than many investors realize.

This is based off research from the Atlanta Fed, which shows the increase in interest rates to date has been more substantial than any of the last five tightening episodes, four of which ultimately led to economic downturns. This is why the Fed will need to cut interest rates at some point soon in order to achieve an economic soft landing.

The Atlanta Fed created a “shadow” fed funds rate. It was designed to measure the full effects of both quantitative easing and forward guidance on interest rates during and after the recent financial crisis.

This rate accounts for these unconventional monetary policy actions, it provides a more accurate reading of the true level of the fed funds rate.

When looking at the Atlanta Fed shadow rate, it is clear the Fed has significantly lifted interest rates over the past four-plus years. While the level of interest rates is low relative to history, the amount of tightening has been large. Rates essentially have increased from -300 basis points (bps) to 240 bps, an increase of 540 basis points.

Furthermore, this does not include the effects of balance sheet maturation, which we estimate could be worth up to another 50 bps in tightening. This is one reason why autos and housing have been softening; the change in interest rates has been quite large, too. But, there are other adverse effects occurring from the Fed’s tightening actions.

Because no other central banks have duplicated the Fed’s tightening actions to date, the U.S. dollar has been very strong. This could weigh on U.S. exports, which would be troubling in light of the recent sharp slowing in capital outlays.

In light of our call for a cyclical weakening in GDP growth this year, the Fed is likely going to have to modestly cut interest rates in an attempt to steepen the yield curve and buoy investor sentiment. A steeper curve will aid credit creation and lower rates will cushion expectations against a more extended slowdown in economic activity.

Post financial crisis, asset prices (in particular equities) have become part of the policy reaction function. Policymakers will have added urgency to respond to any slowing in GDP that is accompanied by a correction in equities.

The Fed will attempt to engineer a soft landing this year and next, modeled on the modest, yet successful, easing in policy following the 1983-1984 and 1994-1995 tightening episodes. In these periods, the economy kept growing for a while afterward. We are optimistic the Fed can pull it off.

Joseph LaVorgna is the chief economist for the Americas at Natixis, a French multinational financial services firm specialized in asset & wealth management, corporate & investment banking, insurance and payments. A subsidiary of Groupe BPCE, it is the second-largest banking group in France.