Thoughts From The Divide: More Cowbell
“The Federal Reserve is independent from politics. That doesn’t mean that politics is independent of the Federal Reserve.”
It’s decision day at the Fed, and we were reliably informed that a lot was riding on the difference between a dovish 25bp vs a slightly hawkish 50bp. Perhaps it was. But it was fair to say that this was the least predictable meeting in years. That does not mean that it was the least predicted: quite the opposite in fact. October fed funds futures contracts show the largest open interest since the contract's inception in 1988, with the bulk of these bets targeting an “outsized half-point cut”. The reader will be unsurprised by our interest in a late flurry of bets on 50bps: why the sudden divergence between traders and economists who leaned towards 25bps? Last week we discussed policymaker “reaction functions”, because it's not always the data that changes. Sometimes it’s the perceived risk-reward of the officials looking at the data. You don’t end up a senior Fed official because of your cavalier attitude towards risk, which one might think creates a bias towards 25bps. After all, some might wonder what the Fed could see that necessitated 50bp? While others might view it as a simple case of “more cowbell”.
All this begs the question why so much recent speculation on 50bps? Our suspicion is that incentives and politics play a part. The Fed might be independent but this is a very close political race. So close, that reasonable (or unreasonable) people might decide that no edge should be left unused. After all, if you ain't cheating you ain't tryin’. And that includes monetary policy. If you want people to feel good about the almost-incumbent candidate, they need to feel good about the economy, which for many means they need to feel good about the stock market. Better lower rates/higher asset prices now, worry about any post-November hangover later. After all, the new incumbent policymakers can address any problems then. Of course, you might take a totally different view if you didn’t have elections.
Over the last few days, various rumors have been circulating suggesting Lael Brainard as the source of some of the speculation about 50bps. We were surprised Bill Dudley’s name didn’t come up. We are not in a position to comment intelligently on the source of the rumors, but we can say that if you want to influence a risk-averse FOMC, the best way to do it is to persuade the market to price 50bps before the meeting. At that point, the risk to the FOMC becomes disappointing the market, and the effective reaction function has been gamed.
Of course, Powell justified the shift with reference to the data (which makes you wonder how so many economists could have gotten this wrong). “This decision 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%”. The market moved to price in an additional 75bps of cuts by year-end, and who would argue against – clearly the reaction function has shifted.
Could there be any downside to cutting too much? Well, strong data, and particularly high CPI prints are potentially embarrassing for the current FOMC: hence Bowman’s dissent. Right now, the balance of policymaker risk/reward suggests officials will try to look through unfriendly data. The worst case would be that surprisingly strong data might mean they had to subsequently reverse policy easing. But in the great scheme of things, would that really be such a disaster?
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