Could A Rate Cut in July Help Bring Down the House?
We normally see interest rate cuts by the Fed as expansionary, and this only makes sense because this increases money supply. Could this end up decreasing it though?
People usually think of economics as a science, and it is in a sense, although it would be more correct to call it both an art and a science. Other branches of what we normally call science have a lot of art in them as well, because the science only starts after we begin with our assumptions.
The quality of science is only as good as the quality of the hypotheses, and this part of things is definitely art. This is especially true with what we term social sciences, but is also with the hardest of sciences, and even what we consider to be science itself isn’t so hard if we are able to understand that even the idea that only the observable can be true is actually very contentious.
If we define knowledge in such a way, and end up proclaiming that only things that can be proven phenomenologically can be proven to exist at all, we have ventured pretty far indeed from what we consider science and are now completely in the realm of philosophy, and practicing questionable philosophy at that.
Matters such as whether a rate cut by the Fed at the end of the month will expand or contract the economy isn’t one of the things that we would think could be contentious or even be reasonably debated, as we know that it’s not the economic effects that we observe when this happens that proves this, it is the mechanism behind these moves that provide their explanation.
We could separate these approaches by calling one theoretical and the other observational. A good idea of an observational approach would be people looking at one thing such as bond yields and looking for correlations, and setting aside any real discussion of how low yields could produce recessions.
It is not enough to even see a strong correlation to explain something, because we might have seen two things occur together very often but there is often an intervening factor that determines this. A recession for instance and low yields go together, and low yields may be a necessary condition of a recession but not a sufficient one, and there are other reasons for the low yields besides a coming recession.
Both during a recession and even in the midst of a coming one, yields are going to be low because the nature of a recession involves negative growth, and negative growth is a sufficient condition of low yields but not a necessary one.
Correlations May Attract Our Attention, But We Still Need to Make Sense of Them
No matter how things end up fitting together, no matter what is correlated, we still need to step back and reason the situation through, to make sure that our assumptions even make sense apart from the data that we are using to justify whatever conclusions result.
When it comes to interest rate cuts, it wouldn’t be hard at all to show that they are correlated with what we would consider to be bust conditions more than they are with boom ones, because this is when we see this sword used, when we get in economic trouble so to speak.
Among the situations that rate cuts are seen to be justified in, none involve an economy that is expanding on its own as we do this only when it is actually contracting, to try to offset the impact of declining economic trends. Monetary policy is only so powerful, and when we look at times where rates have been cut a lot, this has indeed been followed by some pretty lean times, although it’s far more reasonable to think that the lean times happened not because of the cuts but in spite of them. This is especially reasonable given we see the trouble come first and the cuts in response to it.
If we have a kid that can’t pay their bills and we give them a bunch of money to help them, and they still can’t pay the bills, it wasn’t the extra money that we gave them that caused this, it was something else, their having too much debt or spending too much of their money for their own good perhaps.
If they are left better off but still go bankrupt, it wasn’t the help that caused the bankruptcy or even contributed it in any way, so making the connection between the helping and the bankruptcy doesn’t make any sense from a perspective of causation.
We can see the flaws in this belief very easily, but in some situations, the flaws might be better disguised, if the situation isn’t as transparent as our example is. The idea that rate cuts and lean economic times may seem to be transparent enough to even appear ridiculous, but if we muddy the water with such things as the rate cuts causing excess credit and then this causing a bubble that bursts, this might even tempt us to think that this might be reasonable.
This is what Steve Ricchiuto, U.S. chief economist at Mizuho Americas, is trying to sell us, and while it’s quite a novel idea and might seem to make sense, we would need more than just the concurrence of lower rates and credit bubbles to justify it.
We cannot just view the fact that these things correlate to draw any conclusions, even though it may seem that credit defaults and lower rates might have a relationship. Lower rates do mean more borrowing, and higher credit does go together with higher defaults in some cases, but establishing a causative relationship between these two things is going to be more challenging than we think.
The first problem that should stand out for us is that the expansion of credit that expansionary monetary policy causes is just one of its effects. The rest are downstream, as the expansion of credit is just the first step and is not in itself the desired outcome, it is rather the economic growth that this spurs that is what we are really after here.
We might think that our borrowing more may get us in trouble more, increasing our burden, and therefore assume that this is true for the economy as a whole. However, with the economy, the situation is different, as we are not working with spending power that is fixed as it would be in terms of our salary, it depends on increasing our income in turn as well by way of its growing the economy more and providing a greater means for borrowed money to be repaid.
We then need to ask ourselves what really causes recessions, and this never happens when people spend more, it comes when we do the opposite and spend less. Rate cuts have us spending more in the aggregate and with all other things being equal, this will take us away and not toward a recession.
In the early part of the millennium, we were borrowing like mad and we might want to point out that this all did not end well at all. Ricchiuto argues that the Fed contributed to this demise by way of its lax monetary policy where we ended up borrowing too much as a result.
Rate Hikes Increase the Risk of Recessions, Not Rate Cuts
This misrepresents what actually happened though, as it wasn’t the amount that we borrowed that caused this crisis, it was who we were lending so much money to, the unworthy, the sub-prime market. It wasn’t rates that were to blame here, it was a lending strategy totally out of control and doomed to failure completely by way of its structure.
During the three years leading up to the meltdown, the Fed was far from lax and shot up rates from 1% to over 5%. If anything, it was raising rates that made things worse, as if you can’t pay back loans with lower rates, you sure aren’t going to be able to when they go up this much.
The best move in retrospect would have actually been to not raise rates so much, and in spite of the inflationary pressure this would have brought for a time, this would have provided a softer landing when we did hit the rocks with all this subprime debt. These loans were actually predicated on rates not going u, and when they did and renewed at much higher rates, people who were barely able to make the payments were now doomed, and the dominos started to topple very quickly.
There was no way that this would have ever happened because the Fed would need a time machine to see the whole picture, or at least a lot more insight than they had, but it certainly wasn’t rate cuts that precipitated this when we instead jacked them up so much.
He also provides the economic turmoil of the early 21st century as another example of rate cuts bringing down the house, but in this case, rates rose for an even longer period leading up to this, from 2.85% in 1992 to 6.5% 8 years later. This was really not an example of lax monetary policy causing anything because we did not have it then and far from it in fact.
Rather, these are two situations where the brakes were on pretty hard leading up to the point where things turned around, where we now were going uphill rather than down and these brakes slowed us down even more. This is how you get to moving too slow, by having your foot on the brake, not on the gas.
He also believes that “a rate cut will incite undesirable risk taking by borrowers and deepen the next recession.” There is some risk that lower rates present, people borrowing based upon the current rate and then getting smacked later by higher rates, but it’s the rates going up not down that is the pointy end of this.
This is actually why we need to be particularly careful when we put rates up, because the credit that is already out there is going to be subject to more risk, and there is always a lot of credit out there that is exposed to this. We put rates down to provide relief here, to keep risk lower.
People can borrow to their heart’s content provided that we have the proper controls in place, particularly capacity, and this is where we went wrong during the housing crisis because we ignored this risk. Under normal circumstances, addressing capacity will keep our borrowing in line with the current rates at least, although this still may represent some real risk should we up the ante by raising rates and straining capacity more.
The idea that cutting rates will result in economic contraction and somehow bring on or worsen recessions does not make sense on the face of things nor if we look at the situation more deeply. This argument is supposed to rest on correlation and while that’s not a sensible approach, we don’t even have the correlations with this one and actually have one on the opposite side, where raising and not lowering rates go hand in hand with the risk of recessions if anything.
Rate cuts might not help very much now, but they aren’t going to make the economy slow down or precipitate a recession, so we can rest easy about this.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
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