The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
If taken at face value, Federal Reserve chair Jay Powell’s justification for the unusually aggressive start to the central bank’s rate-cutting cycle reinforces the market belief that we never exited, nor are likely to any time soon, the monetary policy regime that first flourished in the run-up to the 2008 global financial crisis.
That regime of ample liquidity provided by the central bank to markets now serves as an insurance policy against an ever-broader range of risks.
It is relatively unusual for the Fed to initiate a cutting cycle with a 0.5 percentage point cut. It is even more unusual for this to happen when, according to Powell, the economy is “in a good place”, the Fed has “growing confidence that the strength in the labour market can be maintained” and fiscal policy has been so consistently loose.
It should come as no surprise that many economic reasons have been put forward for the Fed’s aggressive cycle start. They range from “mission accomplished” in the battle against inflation to an uncomfortably high risk of a recession. Other cited reasons include spillovers from the problems in Chinese and European economies and unusually high real interest rates after taking into account inflation.
Non-economic reasons have also been suggested involving politics ahead of the presidential election, worries that Middle East and/or Russia-Ukraine escalations would undermine global demand and even that the Fed is being bullied by markets that believe it should operate as a single-mandate central bank focusing on just the “maximum employment” part of its dual mandate.
Such speculation is natural in light of the scale of the recent cut, particularly given the dissonances currently running through markets, including the contrast between multiple stock market records and growing economic, political and geopolitical uncertainties; the massive appetite for large new bond issuance despite concerns over high private and public sector debt; and the historically unusual correlation between government bonds, high-yield bonds and gold, all of which have been rallying.
The first set of comments from Fed officials after the policy-setting Federal Open Market Committee meeting do not point to a uniform justification for the aggressive cut. Instead, we have to wait for data releases over the next few weeks to assess, ex post, the central bank’s rationale. If forced today to take a view, I would frame the cut as a combination of a Fed insurance policy against a new policy mistake, this time of being too tight for too long, and the belief of both the Fed and markets that the cost of this policy is very low.
Viewed in a longer-term context, this is yet another evolution in the paradigm of liquidity dominance or what some have called the financialisation of the economy. It was evident in the hyperactivity in private sector factories of credit in the run-up to the 2008 global financial crisis, as detailed in my 2007 Financial Times article.
It continued with the massive market interventions by policymakers with liquidity support to reduce the probability of a disorderly deleveraging of private balance sheets. This reinforced widespread belief in a “Fed put” — the prospect of support for markets from the central bank in times of unsettling volatility. And it was amplified during the Covid-19 pandemic as the Fed’s balance sheet ballooned to $9tn, from $1tn before the financial crisis, amid eye-popping budget deficits. This was despite the record run of 27 consecutive months, up to last May, of an unemployment rate below 4 per cent.
The result of all this has been that liquidity has divorced market pricing from traditional economic, financial, geopolitical and political factors. Indeed, the recent rate cut has fuelled important behavioural tendencies that lead markets to believe that ample liquidity support does more than help them navigate the reality of an uncertain landscape; it also serves to pre-empt a wide range of future threats.
No wonder many have characterised the Fed’s interest rate stance as an “insurance policy”. Its beneficial impact comes with the usual trade-off of generous insurance risking high moral hazard and adverse selection. Specifically, markets have translated this as signalling a low risk of inflation resurgence and disorderly financial instability.
Well-priced insurance policies can add to economic welfare in a win-win-win fashion, for the insured, the insurer and the system. That is the hope economic wellbeing now partly depends on, and it is one that is by no means a slam dunk.
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