The Federal Reserve received praise for cutting interest rates by 50 basis points, but the September non-farm payroll report showed a significant increase in employment numbers, leading to rising bond yields and inflation expectations. The market expressed concerns about the Fed's possible "policy mistakes," but analysts believe it is too early to blame, and there is a disagreement on the definition of "policy mistakes."
Last month, Federal Reserve Chairman Powell and his colleagues were praised for starting a loose monetary policy cycle with a 50 basis point rate cut, with many believing that this would help ensure a "soft landing" for the U.S. economy.
However, following this rate cut, the U.S. non-farm payroll report for September showed remarkable performance, with employment numbers reaching the third largest increase in history since the Fed's transition from a rate hike cycle to its first rate cut. Since then, U.S. bond yields, inflation expectations, and the so-called "term premium" have all soared.
The Fed is currently facing criticism for potentially committing the central bank's biggest sin - policy mistakes. However, history shows that such criticism may be premature.
Market Overreaction?
Since the significant rate cut by the Fed on September 18th, U.S. long-term bond yields, inflation expectations, and the "term premium" (the compensation investors require for buying long-term bonds instead of rolling over short-term bonds) have sharply risen.
Considering that former President Trump seems to be regaining momentum in the presidential race, while advocating a series of potentially budget-busting plans, this may reflect investors' concerns about fiscal profligacy and overly dovish monetary policy.
It is worth noting that these market trends occurred before and after the Fed's rate cut.
Analysts at Bespoke Investment Group pointed out that among the 35 first rate cuts by the Fed since 1994, the 10-year bond yield saw the third largest increase in history, only surpassed by the same period in November 2001 and June 2008.
At the same time, the breakeven inflation rate for 10-year Treasury Inflation-Protected Securities (TIPS) surged by 25 basis points to 2.35%, further away from the Fed's 2% inflation target.
Are these outliers? Certainly. But Reuters columnist Jamie McGeever believes that it may be premature to use them as evidence of "policy mistakes". The following content presents his viewpoint.
The Term "Policy Mistake" May Be Overused
When trying to determine whether any decision by the Fed is a "policy mistake", it is important to acknowledge significant differences in the actual meaning of this term.
This is partly because the Fed always has critics, as TS Lombard's Dario Perkins puts it, they are "apocalyptic". They believe that monetary policy is fundamentally a massive, permanent mistake.
Although the inflation post-COVID was mainly driven by global supply chain blockages, was the Fed's decision not to quickly raise rates from zero a mistake? Many say yes, citing the subsequent close to double-digit inflation as evidence. Additionally, the Fed has also been criticized for not foreseeing the Russia-Ukraine conflict and the subsequent surge in global commodity and energy prices.
However, it is important to remember that supply-driven inflation has largely proven to be temporary.
The debate around whether the Fed should take policy action usually revolves around timing and magnitude, rather than direction. If its actions are a bit too early or delayed, or if it cuts rates by 50 basis points in one meeting instead of 25 basis points in two meetings, then the impact of its policy decisions on the overall economy is different Most central bank observers agree that a definition of "policy mistake" is a decision that is quickly overturned. Some recent examples in Europe meet this standard.
The European Central Bank's rate hikes in July 2008 at the peak of the global financial crisis, and in April and July 2011 during the Eurozone debt crisis, were quite notable.
Policymakers went against the prevailing consensus at the time, as most observers believed that the Eurozone economy needed a looser monetary policy. The policy directions in July 2008 and July 2011 were reversed within a few months.
Even more surprisingly, the Swedish central bank raised its policy rate in September 2008, just days before the collapse of Lehman Brothers. The bank later lowered the policy rate to almost zero within 10 months.
Importantly, these policy reversals coincided with real-world downturns. While it is impossible to know how much damage the decisions of "policy mistakes" themselves caused, it can certainly be said that they were of no benefit.
Patience is Key
So, what does history teach us about the current situation with the Federal Reserve? We must wait.
In hindsight, the Fed might decide that it should have chosen to cut rates by 25 basis points in September instead of 50 basis points, so it might even pause rate cuts next month.
Ultimately, investors cannot accurately assess the Fed's actions until before the presidential election on November 5th, when the outlook for the next four years in terms of taxation, spending, labor markets, and immigration policies will become clearer.
Therefore, perhaps the Fed may have to maintain a slightly tighter monetary policy than originally planned to counterbalance loose fiscal policy, or vice versa. However, if the Fed completely reverses course, making the rate cut in September a true "policy mistake," it would undoubtedly be a significant shock