Beware of the Federal Reserve's "unfamiliar" rate cuts!

Foreign market columnist Jamie McGeever recently wrote that Fed rate cuts are often aggressive. Here are his views.

The pace of the US dollar's appreciation is usually steady, but once it turns, it may plummet rapidly. This pattern also applies to US interest rates, and we may soon witness an unusually large global market turmoil.

The Fed's rate hike cycles are typically gradual, following the famous "measured pace" by former Fed Chairman Greenspan, but rate cut cycles are not the same.

History shows that rate cuts are often large in magnitude and quick in response, as policymakers are forced to take a defensive stance and hastily address out-of-control negative forces, such as economic recession or severe financial market turmoil.

In other words, the economy rarely enjoys the legendary "soft landing." Instead, it often faces an emergency landing. This is because more often than not, lag is a characteristic of Fed policy rather than a flaw.

Chicago Fed President Guersbey stated last Friday that the Fed's task is to act in a "stable" manner.

A paper titled "Lessons from Past Monetary Easing Cycles" released by the Fed in May summarized that "successful policy management seems more likely to be achieved when decision-makers act early, act cautiously, and act preemptively."

Despite their good intentions, decision-makers' responses are rarely stable.

Since 1990, the Fed has raised rates 51 times and cut rates 46 times. Considering that inflation has mostly been below target levels during that period, this may be somewhat surprising. But rate cuts are more aggressive than rate hikes, especially considering the impact of the bursting of the dot-com bubble, the global financial crisis, and the COVID-19 pandemic.

In two of these rate cuts, the federal funds rate dropped to almost zero, and rates remained at this level for nearly seven years in one rate cut cycle.

Since 1990, there have been 40 instances of a 25 basis point rate hike and 11 instances of a hike of more than 50 basis points. Until the global inflation surge caused by the COVID-19 pandemic and the Russia-Ukraine conflict, the Fed only made a one-time 75 basis point rate hike in November 1994. In the recent rate hike cycle, it did this 4 times.

In contrast, since 1990, the Fed has cut rates by 25 basis points 28 times, by more than 50 basis points 18 times, including 7 instances of cutting rates by more than 75 basis points .

In the past 40 years, only two Fed rate cut cycles can be described as smooth and gradual: in the early 1990s, most of the 525 basis point rate cuts were made in 25 basis point increments; in the mid-1990s, the Fed avoided a recession by cutting rates three times by 25 basis points within eight months In many ways, the Federal Reserve is a victim of its own strategy. It is a data-driven, consensus-driven decision-making body, so it must see hard data before taking action. Given its frequent reliance on lagging indicators, it almost always "lags the curve." Its challenge is to ensure that this lag is as short as possible.

Bob Elliott, a senior executive at Bridgewater Associates and CEO of Unlimited Funds, stated that the "fundamental structure" of the Federal Reserve makes it a passive institution with limited predictive ability, so observation is better than prediction. Elliott said, "Another approach is to manage policy based on forecasts and try to lead the curve. Evidence shows that the Fed has almost no ability to predict what will happen."

However, not everyone is so forgiving. Some believe that the Fed's mandate is precisely to adjust policy proactively to meet its dual objectives of "maximum employment and stable prices," and to ensure financial stability.

David Blanchflower, former Bank of England interest rate setter and economics professor at Dartmouth College, said, "Ignoring all recession indicators is very dangerous, just as they did in 2008. Now they are chasing bad data."

Will this time be different?

When the above Federal Reserve paper was published in May, the interest rate market expected the Fed to cut rates by about 125 basis points by the end of 2025. However, as the authors of the paper pointed out, "Compared to historical records, such shallow easing in the first year and a half after the start of loose policy would be unprecedented."

May seems like a long time ago. Now, U.S. stock prices and Treasury yields are rapidly falling, and Wall Street's "fear index" VIX has reached historically high levels except for 2008 and 2020.

If history has any lessons, we should pay attention to the potential for a rapid and substantial rate cut by the Federal Reserve.