A review of the risks that the Federal Reserve needs to pay attention to in the early stages of interest rate cuts

Summary On August 23, 2024, Federal Reserve Chairperson Powell officially announced at the Jackson Hole Global Central Bank Annual Meeting that "now is the time for policy adjustments. The direction forward is clear, and the timing and pace of interest rate cuts will depend on upcoming data, changing prospects, and the balance of risks." This also means that the nearly three-year Fed tightening cycle has ushered in a turning point. If there are no surprises in the macro data, the first interest rate cut will occur at the interest rate meeting on September 19. However, when entering the early stage of the interest rate cut cycle, it does not mean that the surge is coming soon. There are still some risks worth being vigilant about. Therefore, the author summarizes some of the most important issues that need attention at present, hoping to help everyone avoid some risks. In general, in the early stage of the interest rate cut, we still need to pay attention to six core issues, including the recession risk of the US, the pace of interest rate cuts, the QT (quantitative tightening) plan of the Federal Reserve, the risk of inflation reignition, the efficiency of global central bank linkage, and the political risk of the US.

 

First, a rate cut does not necessarily mean an immediate rise in the risk market, but rather a decline in most cases

 

The adjustment of the Federal Reserve's Monetary Policy has a profound impact on the global Financial Marekt. Especially in the early stage of interest rate cuts, although interest rate cuts are usually seen as measures to stimulate economic growth, they are also accompanied by a series of latent risks, which means that interest rate cuts do not necessarily mean an immediate rise in the risk market, but rather a decline in most cases. The reasons for this situation can usually be classified as follows:

 

1. Increased Financial Marekt Volatility

 

Interest rate cuts are usually seen as a signal of support for the economy and the market, but in the early stages of interest rate cuts, the market may experience increased uncertainty and volatility. Investors often have different interpretations of the Fed's actions, and some may believe that interest rate cuts reflect concerns about economic slowdown. This uncertainty can lead to significant fluctuations in the stock and bond markets. For example, during the financial crises of 2001 and 2007-2008, although the Fed began a rate cut cycle, the stock market still experienced significant declines. This was because investors were concerned that the severity of the economic slowdown exceeded the positive impact of interest rate cuts.

 

2. Inflation risk

 

Interest rate cuts mean lower borrowing costs, encouraging consumption and investment. However, if interest rate cuts are excessive or prolonged, they may lead to increased inflationary pressures. When abundant liquidity in the economy chases limited goods and services, price levels may rise rapidly, especially when supply chains are restricted or the economy is close to full employment. Historically, such as in the late 1970s, the Fed's interest rate cuts have led to the risk of soaring inflation, which has forced subsequent more aggressive interest rate hikes to control inflation and trigger economic recessions.

 

3. Capital outflows and currency depreciation

 

The Fed's interest rate cuts usually reduce the US dollar's interest rate advantage, causing capital to flow from the US market to higher-yielding assets in other countries. This capital outflow will put pressure on the US dollar exchange rate, leading to a depreciation of the US dollar. Although a depreciation of the US dollar can stimulate exports to some extent, it may also bring the risk of imported inflation, especially in the case of high raw material and energy prices. In addition, capital outflows may also lead to financial instability in Emerging Markets countries, especially those that rely on US dollar financing.

 

4. Instability of the financial system

 

Interest rate cuts are usually used to alleviate economic pressure and support the financial system, but they may also encourage excessive risk-taking. When borrowing costs are low, Financial Institutions and investors may seek higher-risk investments to obtain higher returns, leading to the formation of asset price bubbles. For example, after the bursting of the technology stock bubble in 2001, the Federal Reserve cut interest rates significantly to support economic recovery, but this policy to some extent fueled the subsequent bubble in the real estate market, ultimately leading to the outbreak of the 2008 financial crisis.

 

5. Limited effectiveness of policy tools

 

In the early stages of interest rate cuts, if the economy is already close to zero interest rates or in a low interest rate environment, the Fed's policy tools may be limited. Over-reliance on interest rate cuts may not effectively stimulate economic growth, especially when interest rates are close to zero, which requires more unconventional Monetary Policy measures such as Quantitative Easing (QE). In 2008 and 2020, the Fed had to use other policy tools to deal with economic downturns after interest rate cuts were close to zero, indicating that the effect of interest rate cuts is limited in extreme cases.

 

Let's look at historical data. Since the end of the Cold War between the US and the Soviet Union in the 1990s and the entry of the world into a global political pattern dominated by the US until now, the Monetary Policy of the Federal Reserve has reflected a certain degree of lag. Currently, it is also in the stage of intense confrontation between China and the US, and the breakdown of the old order undoubtedly exacerbates the uncertainty and risk of policy.

 

Second, take stock of the main risk points in the current market

 

Next, let's take stock of the main risk points in the current market, focusing on the recession risk of the US, the pace of interest rate cuts, the QT (quantitative tightening) plan of the Federal Reserve, the risk of inflation reignition, and the efficiency of global central bank linkage.