Is the Fed overrated?

All eyes have been on the Federal Reserve since the start of the year as to when they will begin cutting interest rates. Both the timing and the extent of a possible cut in the federal funds rate have received ample air time. But it’s growing increasingly obvious that economic actors and investors would be wise to pay less attention to the short-term noise and more attention to the longer-term substance.

Having cut rates to 0 percent in the aftermath of the COVID pandemic in March 2020, the Federal Reserve left rates at 0 percent through May of 2022. From there the Fed embarked upon a serious process of hiking rates, reaching 5.25 percent in July of 2023. The aggressive hikes in the second half of 2022 contributed to severe market volatility for investors but did not lead to the recession that many predicted in 2023.

The Fed’s last increase took place in July of 2023 at which time they began an extended “pause”—with rates still frozen at that 5.25-percent level today. At each of the last five meetings of the Federal Open Market Committee (and counting) the target policy rate has been left untouched. In November of 2023 Fed Chairman Jerome Powell indicated a likelihood of three Fed rate cuts in 2024, and the futures market that prices in these things with actual investor dollars implied an 80-percent likelihood of a rate cut beginning in the March 2024 meeting, with as many as six rate cuts happening in the whole calendar year (or a reduction from 5.25 percent to 3.75 percent by year-end).

March has come and gone with no change in rate policy, and as we stand now both May and June look to have a nearly 0-percent chance of any change, as well. Where we stand now there is a 43 percent chance of a rate cut at the July Fed meeting, and a 65 percent chance of a cut by September. There is an 85 percent probability of some rate cut by the end of the year.

What is telling for market participants is that the S&P 500 was up 10 percent in the first quarter of the year despite expectations for the Fed’s first rate cut being pushed out several months and the total amount of presumed rate cuts being dramatically reduced. Markets are, always and forever, discounting mechanisms, pricing in today what they believe about the future—and they usually like lower interest rates. First, markets have a vested interest in rates being reduced before collateral damage to the economy occurs—whether it be in the form of job terminations, wage pressure, or contraction of corporate profits. Second, to the extent the interest rate represents a sort of “valuation metric” for asset risk, a lower rate (with lower returns) on low-risk investments makes riskier investments more attractive. So why have markets so far shrugged off the Fed’s “kicking of the can” in beginning to cut interest rates?

First of all, markets believe the Fed will be cutting this year, and whether it began in March or September never really mattered much, as long as it happened before pressure on economic health and corporate profits materialized. Second, it is been clear for about a year now that the high level of interest rates that has worked its way into the mortgage market has not cratered the housing market, but rather frozen it. Sellers are not inclined to sell a home with a low-cost mortgage when a new house would have a high mortgage rate. And buyers are not inclined to overpay for a home when rates are 2.5 times the place they were just three years ago. The consequence has been a market stand-still. Normal collateral damage to downward pressure in housing—such as forced sales, a foreclosure boom, severe distress, a contamination in the construction industry—has simply not happened.

By the end of 2024, expect the Fed to reverse its current policy of quantitative tightening (reducing financial liquidity in the banking system), and to take action to leave bank reserves at their current levels (or more). A freeze of quantitative tightening (if not a return to quantitative easing) and some modest rate reductions, likely policy outcomes in my view (though not assured), are the next iteration of a central bank that has been granted excessive bandwidth in its stewardship of policy. This highly discretionary approach to monetary policy screams for something more rules-based, and in the meantime this boom-bust alternation seems to be the new normal.

Will the Fed pull off the perfect scenario for 2024—holding rates up long enough to see policy objectives met yet begin cutting rates before markets revolt and economic damage becomes visible? Perhaps the better question ought to be—why do we want 12 people sitting around a conference table to be in charge of such important policy decisions all on their own? Or better yet, maybe, just maybe, the lesson of the last few years is that the Fed is in charge of a lot less than we give them credit for.