Global Markets Surge as Fed Cuts Rates for First Time in Four Years

Global Markets Surge as Fed Cuts Rates for First Time in Four Years 

The Federal Reserve recently made a significant decision to lower interest rates by 50 basis points, despite Chairman Powell's assertion that the U.S. economy is "solid," with a strong labor market and "no risk of a recession." This move comes after years of the Fed largely disregarding the influence of monetary aggregates and overlooking early inflation warnings. For three consecutive years, the central bank has failed to meet its mandate of price stability, focusing instead on injecting liquidity, or effectively printing more money, rather than restoring the purchasing power of the currency.

The Fed's much-publicized "higher for longer" interest rate strategy lasted only 18 months. In addition, recent data from the Chicago Fed National Financial Conditions Index suggests financial conditions are remarkably loose. Historically, the Fed has never reduced rates so drastically when conditions were this accommodating. Given the Fed's own analysis that the economy is stable, the labor market is strong, and inflation—particularly core CPI—remains above target, it raises the question of why rates are being slashed so rapidly. What's the underlying reason?

The answer may lie in politics. The Federal Reserve has effectively intervened to support the government in the midst of an election year, raising questions about its independence. The decision to cut rates appears to aid a government burdened by excessive debt, with rate reductions being leveraged as a tool in the political arena.

The Fed's reaction was notable, not in response to the revision of employment figures that resulted in the loss of 818,000 jobs, but in June when it hesitated in its tightening cycle, coinciding with a sharp rise in sovereign bond yields. Despite persistent inflation and an overheated economy, the Fed chose to slow its reduction of securities holdings, lowering its monthly Treasury redemption cap from $60 billion to $25 billion. Furthermore, it pledged to reinvest any principal payments above this cap into Treasury securities. The spike in two-year Treasury yields to 5.03% between January and May 2024, despite seemingly strong economic indicators, signaled the Fed's concern and led to these actions.

The fiscal situation under the Biden-Harris administration exacerbated the Fed's challenges. Despite record tax revenues and stronger-than-expected GDP growth, fiscal mismanagement caused the annual deficit to balloon. While headline figures painted a picture of strength, underlying issues—such as a weakening labor market and a less productive economy—remained hidden. The Fed's initial loosening actions followed the Treasury yield spike and a decline in foreign demand for U.S. public debt.

The situation only deteriorated after the "quiet easing" in June. By the end of the first eleven months of fiscal year 2024, the U.S. budget deficit had surged to $1.897 trillion, with annual interest payments on public debt exceeding $1 trillion for the first time. Treasury projections predict a further $16 trillion in government debt over the next decade. Additionally, the Congressional Budget Office estimated that the Harris economic plan would add another $2.25 trillion in debt.

The Fed's aggressive rate cuts were designed to stabilize Treasury yields, but the long-term impact on the economy is doubtful. Despite falling rates, mortgage costs remain high, financial conditions haven't substantially improved, and household debt levels are at record highs. The Fed's actions might provide temporary relief to the government but are unlikely to resolve the broader fiscal issues facing the U.S. economy. Continued rate cuts will increase debt and erode confidence in the dollar, both domestically and internationally.

As the Federal Reserve continues to prioritize government debt over price stability, the U.S. risks following in the footsteps of Japan, facing stagnation and a decline in the U.S. dollar's status as a global reserve currency.