Fed Cut Rate But Yields Surge

Powell Missed Monetary Economics 101

When the Federal Open Market Commitee cut the policy rate by a more-than-expected 50 basis points last month, Chairman Jerome Powell could not have anticipated a market week like the last one. Recall that he said at his post-FOMC press conference on September 18 that the Fed had shifted attention from inflation to jobs. There was near-unanimity among other senior FOMC officials in following the Chairman’s wish — there was only one dissent. Powell must have thought that the move would result in a decline in longer-term yields and, with that, falling mortgage rates benefiting first-time home buyers.

The Kamala Harris presidential campaign team must have been pleased with the Fed decision. And of course, everyone knows that Powell’s current term as Chairman expires May 2026, and is subject to renewal by the next President.

Unfortunately for the Chairman and his fellow-decision makers, the market had a mind of its own. Rather than decline, the yield on 10-year Treasurys surged from 3.62% just before Fed decision to close at 4.24% last night. Even more important to the housing sector and to the economy, the fixed rate for 30-year mortgages jumped over the same period from 6.13% to 6.54%.

It was the adverse reaction from long-dated Treasury yields that led senior Fed officials to veer away from the Chairman’s message that the fight against inflation had been almost completed. Last week’s SriKonomics referred to public statements by Fed Governor Christopher Waller and Atlanta Fed President Raphael Bostic that they would suggest being more careful with future rate cuts. Bostic indicated that he may even call for a pause at the next meeting set for November 6 - 7.

Lorie Logan, President of the Dallas Fed, and head of the all-important markets desk at the New York Fed in a prior life, recognized the “still real” upside risks to inflation as she signaled smaller rate cuts ahead. Unfortunately, her concerns did not stop her from expressing support for the jumbo rate cut on September 18.

On the other hand, readers of SriKonomics have read my counsel for the Fed before its decision, ad nauseum, not to reduce the rate at all. A still vibrant economy, and inflation above target, would only provide more stimulus to consumer spending and rekindle inflation. Recognition of this reality by the bond market — more sensitive to inflation expectations than equities — has been a major factor in the upturn in long-dated yields.

Furthermore, both the DXY dollar exchange rate index and the price of gold signal that it may no longer be viable for the central bank to cut rates with abandon as the Powell-led team did on September 18. The DXY index rose from a recent low around 100 at the end of September to 104.3 last night. The price of gold fell from a record high of $2,770 per ounce on Wednesday to close the week out at $2,761.

What if Chairman Powell once again leads a decision to reduce rates next month? Even though the US presidential elections would have been concluded before the Fed decision, the temptation would persist among Fed officials to please the President-elect with a rate cut. Another policy easing may well accelerate the upward move in yields, once again frustrating Fed officials’ efforts to reach their objective.

It may help Fed decision makers to understand the first principles in monetary theory. The central bank can only decide on the short-term policy rate. Longer-term yields are set by the market, among other things, by incorporating implications of the latest Fed move for inflation expectations. If investors collectively decide that a rate cut is inflationary, they can negate its impact by increasing long-term yields.

For Jerome Powell, the first Fed Chairman in more than four decades not to have had formal training in Economics, it may be quite a lesson!

Dr. Komal Sri-Kumar

President, Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

October 26, 2024

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