Blunt Interest Rates Raise Questions About Fed Easing: Mike Dolan

By Mike Dolan

LONDON (Reuters) – Given that significant interest rate hikes have not substantially slowed the U.S. economy in recent years, it’s logical to question whether reversing those hikes will have a considerable effect during a downturn.

One of the mysteries of the past two years has been how the Federal Reserve’s five percentage point increase in rates between March 2022 and July 2023 had such a minimal impact on the overall economy. Despite a tighter borrowing environment, U.S. real GDP has recorded annualized growth rates exceeding 2% in seven of the eight quarters since mid-2022 and is projected to continue this trend through the end of September.

Moreover, despite some fluctuations, the stock market remains near record highs. This suggests that the economy may have become less sensitive to changes in short-term borrowing costs. If true, policymakers might be concerned that any slowdown going forward, including a possible recession, could also be unresponsive to monetary policy easing.

Several theories attempt to explain this resilience to higher rates: the unique circumstances of the COVID-19 pandemic, such as increased household savings and government expenditures prior to the tightening; the prevalence of fixed-rate debt in the U.S., especially in mortgages; and the high levels of corporate cash that have cushioned small businesses from rising debt servicing costs.

The latter point is particularly noteworthy. According to a recent International Monetary Fund report, U.S. firms’ net interest payments as a share of GDP were halved during the tightening cycle. Additional research indicates that net interest payments of U.S. firms relative to cash flow have also fallen to their lowest levels in nearly 70 years.

LOW SENSITIVITY TO RATES

What does this mean going forward?

Interest rates are expected to decrease, with the Fed likely initiating easing measures soon. But considering the limited economic impact during the rate increases, some analysts contend that the central bank may need to reduce rates dramatically to stimulate the economy in the event of a recession.

Conversely, others argue that the effects of higher rates may simply have been delayed, with the gradual impact observable in the diminishing cash reserves of certain households and corporations.

Nonetheless, corporate borrowers are finding it manageable to refinance their debts, even at higher rates. Recently, 59 new debt offerings totaled over $81 billion, marking the fifth-highest weekly volume recorded for investment-grade companies.

Some investors believe this complex scenario should lead to a more cautious approach from the Fed than what markets currently anticipate.

Yves Bonzon, the chief investment officer at a prominent financial institution, highlights significant uncertainty regarding how monetary policy affects the private sector. He suggests that interest rates have primarily increased to restrain an income-driven rather than a debt-driven economic expansion.

"If the real economy’s responsiveness to interest rates is unusually low, it’s uncertain how asset prices will react if the Fed aligns with market expectations and implements aggressive rate cuts," he noted.

Bonzon believes that Fed easing without a recession could stimulate rising private-sector credit growth, rejuvenate the housing market and related industries, and even reinvigorate the struggling leveraged buyout and private equity markets. He cautioned that the Fed should be wary of triggering an asset price boom-and-bust cycle, suggesting that starting with three quarter-percentage-point cuts would provide sufficient time for evaluation.

For credit strategists, the interpretation of the Fed’s actions is key. Are they easing in response to potential recession indicators, or are they simply recalibrating following a moderation in inflation?

If the former is true, deep rate cuts might follow alongside an increase in high-yield credit spreads due to recession fears. Conversely, if the Fed is merely normalizing rates, its terminal rate could settle around 3.5%, with credit spreads remaining stable.

In any case, it is clear that the future direction remains uncertain, both for the Fed and investors, who should anticipate more volatile months ahead.

The views expressed here are those of the author, a columnist for Reuters.