The Breakdown - Was the Jumbo Rate Cut "Normalization" or Signs of Trouble Ahead?

Episode Date: September 20, 2024

The rate cutting cycle has finally arrived and Powell et al went for 50bps. In today's episode, NLW explores how much the decision was about rate normalization vs. brewing economic weakness Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the Big Picture Power Shifts remaking our world. What's going on, guys? It is Thursday, September 19th, and today, you better believe we are talking about that jumbo rate cut. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown. Well, friends, after more than a year of holding rates high, the Federal Reserve has delivered their first rate cut. For the past month, it's been clear the cutting cycle would begin at this FOMC meeting.

The question then was how large the cut would be. Sure enough, when push came to shove, the Fed kicked off the easing cycle with a jumbo-sized 50 basis point cut. The last time the first rate cut was larger than normal was in September 2007, as the first dominoes began to fall in the global financial crisis. The Fed funds rate is now in a range between 4.75 and 5%. Chair Jerome Powell went to pains in order to frame these cuts as completely normal and no reason for alarm. Presenting the rate decision, he said it, quote, reflects our growing confidence that with

an appropriate recalibration of our policy stance, strength in the labor market can be maintained in a context of moderate growth and inflation moving sustainably down to 2%. There always seems to be a word with each Fed meeting, and this Fed meeting's word of the day was recalibration. Powell explained the Fed's intention was to slowly recalibrate rates out of restrictive territory. Part of the language decision was coming from the fact that many had been concerned that a double cut would spook markets, with traders wondering if the Fed knew something that they didn't. Powell made it clear that the only thing that he's seen is that rates are too high to allow for a

strong economy, and it's now appropriate to bring them down. In other words, he used the language of a soft landing even if those words specifically were not used. The cuts were presented as policy normalization rather than a drastic measure. Powell didn't even mention the need to support the economy with accommodative rates, making it clear that the target is only to get to a neutral policy stance. In addition to the policy decision, this meeting also featured the quarterly summary of economic predictions or the SEP.

That report includes the dot plot, which maps the rate forecasts of each of the 19 Fed officials. On this, there was a fairly widespread of opinions. Officials were close to evenly split between delivering one or two additional rate cuts at the final pair of meetings for this year. There was one outlier who believed three more rate cuts would be appropriate this year, while two officials forecast no further rate cuts until next year. Notably, this was the first FOMC meeting since 2005 that featured a dissenting opinion from a Fed governor. Michelle Bowman went against the rest of the committee and voted to cut by only 25 basis points. Powell noted that although there

is disagreement on how fast the Fed should cut over the remainder of the year, it was unanimous that the cutting cycle needed to begin at this meeting. He said, there is dissent and there's a range of views, but there's actually a lot of common ground as well. Looking out further in the rate projection, forecast diverge even more. Officials believe that between three and eight rate cuts should be delivered by the end of next year, with a median of six. Over the longer term, officials are even more mixed. They believe rates should land somewhere between 2.25 and 4%. Still, while there's no agreement, there's also no sign of panic. No one is expecting the need to take rates into emergency territory based on the current path of the economy. Looking over the other forecasts, Fed officials expect the

economy to get slightly worse over the next year, but not to an alarming level. The median projection for end-of-year unemployment was 4.4%, a few ticks higher than the current level. They expect the long-term equilibrium unemployment rate to settle at 4.2%, which would be historic lows. Headline PCE inflation is currently at 2.2% and officials expected to tick up slightly into the end of the year. Officials still expect the last mile of inflation to take some time, forecasting another two years until they reach their 2% target. Now, unlike most cutting cycles, Powell emphasized that that there is no sense of urgency, stating, there's nothing in the SEP that suggests the committee is in a rush.

The last three times the Fed began to cut rates, the economy was already in the middle of a clear crisis. This time, there's signs of growing weakness, but nothing approaching a calamity. Powell declined to give much in the way of specific guidance, preferring to keep as much optionality on the table as possible. He said, the actual things that we do will depend on the way the economy evolves.

We can go quicker if that's appropriate. We can go slower if that's appropriate. We can pause if that's appropriate, but that's what we are contemplating. To the extent that there is trouble in the economy, it's showing up as a small but persistent rise in unemployment. Yet at this meeting, Powell didn't seem concerned, at least not yet. He said, the labor market bears close watching and we'll be giving it that.

But ultimately, we believe, with an appropriate recalibration, there's that word again, of our policy, that we can continue to see the economy growing and that will support the labor market. If you look at the growth in economic activity data, all of this indicates an economy that is still growing at a solid pace, so that should also support the labor market over time. But it bears watching, and we're watching, end quote. Heading into the meeting, there was some concern that the Fed was already behind the curve. July unemployment data came in shortly after the last FOMC meeting and confirmed

labor market weakness. When asked, Powell confirmed that with the benefit of the data, the Fed might have decided to cut at the July meeting. However, he didn't seem to think that missing the first opportunity to cut rates was a particularly big deal, nor that it put the Fed in a position where it needed to play catch-up. He said, I think our move is timely. You can see our 50-Bases Point move as a commitment to make sure we don't fall behind. Once again, Powell called into question the accuracy of jobs data.

Last month, the Bureau of Labor Statistics released their annual revisions to the non-farm payrolls report. They found that a massive 818,000 fewer jobs were added to the economy over the past year compared to initial data. Opinions differed on why there was such a large discrepancy and what should be done about it. But the clear takeaway was that jobs data is coming in much hotter than it should be. Powell said the FOMC was still considering every data point, but that they would be,

quote, mentally adjusting non-farm payrolls down to account for the data error. As for the data he does like, Powell mentioned the beige book multiple times. The beige book is a collection of anecdotal data collected from businesses and nonprofits across each of the 12 Fed districts. Last month's edition said that economic activity was flat to slightly down across the entire country. Powell seemed to dodge this pessimistic assessment, instead stating that 2025 is looking like a strong year, end that, quote, the U.S. economy is basically fine if you talk to business

people who are actually out there doing business. He pushed back when asked if the Fed had already missed their chance to address rising unemployment, stating, we're not seeing rising claims, we're not seeing rising layoffs. We're not seeing that and we're not hearing that from companies. On inflation, there was frankly very little measure of inflation beyond the idea that the issue is under control. Powell was asked whether the Fed was declaring victory over inflation. And clearly with the legacy of the 70s burned into his mind, Powell responded, no, no, we're not. The goal is to have inflation move down to 2% on a sustainable basis. We're close, but we're not really at 2%. And I think we're going to want to see it be around

2% and close to 2% for some time. We're certainly not saying mission accomplished or anything like that, but I have to say we're encouraged by the progress that we have made. One journalist noted that the Fed is continuing to shrink their balance sheet at the same pace while simultaneously cutting rates. According to economic orthodoxy, this shouldn't happen. The thought is that balance sheet reduction is the same as monetary tightening via rate cuts, which would have the Fed pushing in opposite directions at the same time. Powell pointed out, though, that bank reserves are still ample, and that balance sheet reduction has mainly drained excess funds out of the Fed's reverse repo facility. His implication was that the Fed's balance sheet is still accommodative at these levels.

He was quite comfortable to cut rates while still reducing the balance sheet stating, we're not thinking about stopping runoff because of this at all. We know that the two things can happen side by side. In a sense, they're both a form of normalization, and so for a time you can have the balance sheet shrinking but also be cutting rates. And indeed, if recalibration was the word of this meeting, normalization was really the big theme that Powell was trying to get across. All of his framing was based on the idea of shifting Fed policy from restrictive territory back to

neutral. Again, there was no hint of panic or really even any acknowledgement of anything more than mild softening in the economy. Throughout the press conference, Powell insisted that the economy was still strong and simply needed rates at more reasonable levels in order to persist. He framed the 50 basis point cut as an option that was open to the Fed, which they gladly accepted, rather than an action they were forced into. At one stage, he was asked directly about the risk of recession, and even corrected himself when repeating that word, answering, I don't see anything in the economy right now that suggests that the likelihood of a recession, sorry, of a downturn is elevated. I don't see that. You see growth at a solid rate. You see

inflation coming down. You see a labor market that's still at very solid levels. So I don't really see that, no. This was the takeaway that they were clearly trying to convey. The Fed isn't worried, so you shouldn't be either. There's nothing to read into a 50 basis point cut. It was simply the most appropriate choice. Hello, friends. Before we get back to the rest of the show, I want to implore you to join me at Permissionless. Permissionless is the conference for crypto-natives by crypto-natives, and the reason it's so important this year is that despite regulators' best attempts to push industry founders, devs, and executives out of the U.S., the United States remains the beating heart of crypto.

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If you want to get 10% off, use code Breakdown 10. Go to the Blockworks website, blockworks.co. There will be links to register for the conference, and again, you can use Code Breakdown 10 to get 10% off. There were a few tangential points that provided some extra color on how the Fed is thinking about this moment. in history. The first related to politics. Once it became clear that the Fed would be cutting right before the election, Powell began fielding questions about whether the Fed takes politics into consideration. At first, he was visibly irritated by the implication that his Fed would put their thumb on the scale. Now he has had a few months to practice his responses and delivered them in a much more measured tone.

Cutting rates six weeks out from an election has unavoidable political connotations, let alone choosing to deliver a double cut. Powell explained, this is my fourth presidential election at the Fed, and it's always the same. We're always going into this meeting in particular and asking what's the right thing to do for the people we serve. And we do that, we make a decision as a group, and then we announce it. Our job is to support the economy on behalf of the American people. If we get it right, this will benefit the American people significantly, so this really concentrates the mind. We don't put up any other filters. He also fielded a more pointed question about Fed independence. Earlier in the campaign,

Donald Trump suggested that the president should have direct input on monetary policy. Powell responded by explaining the logic behind Central Bank independence, stating, democracies around the world all have independent central banks. People have found over time that insulating the central bank from direct control by political authorities avoids making monetary policy in a way that maybe favors people who are in office as opposed to people who are not in office. I think the data are clear that countries that have independent central banks get lower inflation, and so we do our work to serve all Americans. We're not serving any politician, any political figure, any cause, any issue, nothing. It's just maximum employment and price stability on behalf

of all Americans, and that's it. It's a good institutional arrangement, which has been good for the public, and I hope and strongly believe that it will continue. The second point of interest was a discussion of the long-term neutral rate and whether or not we've seen the end of zero-interest rate policy. The neutral rate refers to a Fed policy setting that neither restricts nor boosts economic growth. There has been some suggestion that the neutral rate has risen since the pandemic, and the structural changes it brought to government spending in the economy. That showed through in the SEP, which estimated the neutral rate at 2.9%, although with a massive spread of opinions. Powell said, I think every single person on the committee, if you ask them what's your level of

certainty around that, they would say there's a wide range where it could fall, so I think we don't know. Despite that uncertainty, Powell was fairly confident that the Zerp era is over. He commented, intuitively most people would say we're probably not going back to that era, where there were trillions of dollars of sovereign bonds trading at negative rates, and it looked like the neutral rate might even be negative. It seems that's so far away now. My own sense is that we're not going back to that, but honestly, we're going to find out. The meeting ended with no fine-tuned guidance but a general idea of where the Fed is heading. The rest of the year should see somewhere between two and three additional cuts provided the economy plays out broadly in line with expectations.

The Fed is aiming to get rates to neutral and doesn't see the need to rush the process. That neutral rate could be anywhere from 2 to 4%, but the Fed is willing to play it by year. Starting with 50 basis points isn't anything but an opportunity to make a strong start, and the Fed will likely shift down to single cuts beginning at the November meeting. In other words, this is definitely the start of the cutting cycle, but there is no clear indication of how fast or deep it will be. This is a recalibration, a normalization, and that is all. Lastly, today, what do the markets think about all this?

The market response was initially strong, with stocks roaring in response to confirmation of a 50 basis point cut. The rally was cut off, however, when Powell explained that the jumbo cut was a once-off, and no one should expect a repeat in November. Bitcoin followed the same pattern, but rallied strongly into the evening, reaching a three-week high of 62,600. Tom Porcelli, chief U.S. economist at PGM, fixed income, said, this is not the beginning of a series of 50 basis point cuts.

The market was thinking to itself, if you go 50, another 50 has a high-legal. But I think Powell really dashed that idea to some extent. It's not that he thinks that it's not going to happen. It's that he's not pre-committing to that to happen. To be clear, at times over the past month, the markets have been pricing in as many as 10 rate cuts by the end of next year. No one on the Fed was anywhere close to that, dovish, and simply didn't see the need to do anything other than normalizing rates. All in all, this could be a very strange cutting cycle. There are very few people on Wall Street who were actively trading the last time the Fed cut rates simply because they were too high rather than in response to a crisis. The last time that

happened was in 1995, when the entire easing cycle saw just 75 basis points and cuts. If Powell manages to get through the next year without a major calamity or a recession, there probably won't be any need to bring rates below 2%. And it seems clear there is no appetite at current to bring rates anywhere close to zero unless the economy really falls apart at the seams. James McIntyre of Brandywine Global Investments thinks this cutting cycle is clearly different to anything we've seen in decades, stating, a more prolonged and predictable easing cycle is at hand. It now will be a battle between market expectations in the Fed, with employment data, not inflation data, determining which side is right. The moderate rate path that Powell is setting out could end up disappointing markets.

This was on full display yesterday, with Michael DePas of Citadel commenting, it was always going to be difficult for Powell to outdove the bond market given how much it had moved in the last six weeks or so. Charlie Ripley, senior investment strategist for Allianz, thinks the slow and steady approach will be just fine. He said, while we can all debate the warranted speed of rate cuts out the gate, the reality is the direction of travel for policy rates is lower. The track record from this Fed has shown they haven't historically been the fastest out of the gate, but they have exhibited the ability to dial up a pace when deemed necessary. So that is the story from here. I'm sure there will be lots more analysis. For now, though, that is going to do it for today's

breakdown. Appreciate you listening as always. And until next time, be safe and take care of each other. Peace.