Nothing Will Stop the Fed from Cutting
The economic news that arrived as the Federal Reserve began its two-day meeting Tuesday suggests that the economy continues to grow more rapidly than expected, boosted by a surprisingly strong report on consumer spending and a big jump in industrial output.
The Fed said that industrial output rose by 0.8 percent in August, easily beating expectations for a mere one-tenth of a percentage point growth. This was driven by growth in the economically sensitive parts of the monthly industrial production report, with manufacturing growing 0.9 percent and mining—which includes oil and gas drilling—growing 0.8 percent.
Retail sales were also strong, rising 0.1 percent. Once you exclude motor vehicles and gas, sales were up 0.2 percent. Compared with the first eight months of last year, sales are up 2.9 percent overall and core sales are up 3.7 percent. The long-awaited collapse of the American consumer is still nowhere near arriving.
After this morning’s reports, Goldman Sachs just raised its estimate for third-quarter GDP growth to 2.8 percent, and the Atlanta Fed’s GDPNow model just adjusted its forecast from 2.5 percent to three percent.
You’d think the champagne would be flowing at Federal Reserve headquarters. Recall that the Fed thinks the long-term potential growth rate of the economy is just 1.8 percent and the Fed’s last projections had the median growth expectation for this year at two percent. So, we’re growing more than 50 percent faster than potential and on track to beat the forecast of Fed officials by half a percentage point or so.
This has all the makings of a soft-landing—if only the Fed could resist jumping the gun by easing monetary policy. But instead, officials are preparing to do the one thing they’re famous for: cut rates at precisely the wrong time.
Tomorrow, the Fed will conclude its September meeting, and the expectation is they’ll cut rates by as much as 50 basis points. That’s right, a half-percent cut, in an economy running close to three percent growth with unemployment at historically low levels. This is the kind of thing the Fed excels at: a preemptive strike when there’s no visible slump, just a vague sense that one might appear on the horizon. In fairness, it’s a game they’ve played before, often with short-term success but longer-term regret.
Strong growth, low unemployment, and uncertainty around inflation has not stopped the Fed from cutting rates in the past. Spoiler alert: inflation or asset bubbles always seem to find a way to ruin the party.
1965: Preemptive Cut That Set Inflation on Its Path
In 1965, the U.S. economy was booming. GDP was growing at a sizzling 6.5 percent, and unemployment had dipped below 4.5 percent—essentially a textbook case of full employment. The inflation rate was a calm 1.6 percent, the perfect setting for the Fed to, well, do nothing. But central bankers hate standing idly by when they could be tinkering, and so the Fed cut rates preemptively to keep the economy rolling along.
And roll along it did, at least for a bit. The stock market responded enthusiastically, with the S&P 500 gaining 9.1 percent in 1965. But by 1966, the real story started to unfold. Inflation had climbed to three percent, and the market, no longer thrilled with the Fed’s handiwork, dropped by over 13 percent. By 1967, inflation had grown even more stubborn, hitting 4.2 percent, and the Fed, in a moment of belated realization, began raising rates to cool things off.
It turns out that cutting rates with GDP growth north of six percent and unemployment under 4.5 percent is a great way to fan the flames of inflation—something the Fed should have learned the hard way. But, as we’ll see, it’s not clear the Fed learned anything at all.
1967: Deja Vu All Over Again
If the 1965 preemptive cut was a lesson unlearned, 1967 was a case of the Fed doubling down. The economy was still strong, with unemployment at a cozy 3.8 percent and GDP ticking along at 2.7 percent. Inflation, however, was already creeping up to three percent when the Fed decided to lower rates again. Why? To ensure growth, of course—because what’s a little inflation when growth is at stake?
The stock market, true to form, threw a celebratory rally, with the S&P 500 gaining over 20 percent in 1967. But the party didn’t last long. By the end of 1968, inflation had surged to 4.7 percent, forcing the Fed to raise rates and tighten credit to contain the spiraling price increases. By 1969, inflation had reached a painful 5.4 percent, GDP growth had slowed, and the stock market lost 11.4 percent—a stark reminder of the cost of stoking inflation.
Once again, the Fed’s good intentions paved the way to inflationary hell.
1998: A Crisis Avoided, a Bubble Created
Skip ahead to 1998, and we find the U.S. economy in a similar position to today—strong growth, low unemployment, and a central bank feeling the need to act. GDP was growing at a 4.6 percent annual rate, unemployment was a low 4.2 percent, and inflation was a tame 1.6 percent. Despite this, the Fed swooped in to save the day, cutting rates three times in the back half of 1998 to ease market jitters over the Russian debt crisis and the collapse of Long-Term Capital Management.
The market loved it. The S&P 500 rocketed nearly 30 percent in 1998, and by 1999, it added another 19.5 percent. For a while, it seemed like the Fed had done what it does best—inflate the stock market. But inflation, always lurking in the shadows, started ticking up. By the end of 1999, inflation hit 2.7 percent, and by early 2000, it climbed to 3.4 percent. The real problem wasn’t inflation, though—it was the tech bubble. By mid-2000, the bubble burst, and the market lost 10 percent by year-end, with worse still to come.
So, while the Fed may have rescued markets in 1998, it also sowed the seeds for the tech wreck of 2000.
2024: Another Round of Preemptive Cuts?
Fast forward to today, and the Fed seems poised to replay its greatest blunders. Inflation is still well-above the Fed’s two percent target, clocking in at 2.5 percent in August. Core inflation is running at 3.2 percent. Median CPI, as calculated by the Federal Reserve Bank of Cleveland, has been alternating between 4.2 and 4.3 percent for four months on a year-over-year basis. The three-month annualized average is around 3.1 percent. This is one of the best indicators of underlying inflation, and the message is clear: inflation is stuck at an elevated level.
Despite strong growth and stubborn underlying inflation, the Fed has made it clear that it is about to begin a rate-cutting cycle.
Of course, markets love it when the Fed cuts rates, and we’ll likely see the S&P 500 react with yet another rally—especially if the Fed gives the market the 50 basis point cut it is craving. But if history is any guide, it’s only a matter of time before inflation comes calling and the Fed is forced to slam on the brakes. The problem with preemptive rate cuts is that they rarely come without consequences—typically in the form of inflation and market bubbles that burst in spectacular fashion.
The Fed’s Eternal Dance with Inflation
In each of these cases—1965, 1967, and 1998—the Fed’s decision to cut rates, even when the economy was growing and unemployment was low, provided a short-term market boost but led to longer-term inflationary headaches. Inflation doesn’t just disappear because the Fed says so. It builds quietly, almost imperceptibly, until it can no longer be ignored. And by the time the Fed finally acts, the damage is done, and markets have to reckon with the inevitable rate hikes that follow.
As the Fed prepares to cut rates again, it’s worth remembering that rate cuts are never free, even when they seem like an easy fix. For the market, it’s always fun while it lasts, but the reckoning is rarely far behind.
So, enjoy tomorrow’s rally—just be sure to have an exit plan before the bill comes due.
