Cutting from strength not weakness

The Fed goes Big

The US Federal Reserve (Fed) voted to cut its interest rate by 50 basis points – an aggressive start to the easing cycle given how such large moves are rarely seen outside crisis periods and recessions.

The tone of the policy statement and speech suggested a change in their assessment of the balance of risks between inflation and the labour market. In particular, the risks of rising unemployment have increased and so too has their willingness to contain this scenario in advance.

Short-maturity bond yields dropped after the news while long-maturity bond yields increased (note that past performance is not a reliable guide to future performance). This ‘steepening’ of the yield curve essentially tells us that front-loaded stimulus is expected, according to markets, to bolster medium-term growth. With the Fed prepared to support the economy, naturally equity prices soared too.

In contrast, the Bank of England voted to keep interest rates steady at 5%, citing concerns about not cutting too fast or too much. With domestic activity performing reasonably well lately and services inflation lingering at 3.5%, the case for aggressive easing indeed looks weak.

I don’t smell doom

We don’t subscribe strongly to the view that the US economy is on the cusp of a major downturn given the mixed signals emanating from various soft and hard data metrics. While the labour market is clearly weakening, this may not be a harbinger of doom.

For a start, US retail sales released last Friday showed that consumption is chugging along. Similarly, consumer sentiment has improved recently. It just doesn’t look like an economy that is flashing real trouble ahead. Even economists are heeding this message, with revisions to their growth forecasts now starting to pick up again.

It's a different story in the Eurozone where data just keeps looking lacklustre. It’s fairly widespread too, with consumer spending and industry production failing to rebound. Questions linger over how much economic damage it will take before the European Central Bank acts more swiftly to lower its policy rate. For now, their assessment is that slaying the inflation beast is more important.