Why the Fed should not, and may not, cut today

It has been an eventful week with, by any measure, an election for the ages. What really stuck out to me is how wrong the pollsters got it and how right the prediction markets were. Yes, during the later days of the race there was talk (mostly from pollsters) that the prediction markets might be rigged. In retrospect, that theory didn’t hold up. It should come as no surprise that when investors have “skin in the game” they tend to make better forecasts overall, since the payoff for being right is profit, not just a tick on the reputation table. They have skin in the game, in other words. As an investor, it is not just enough to be right, it is also essential to get the consequences right in real time.

As with all previous elections, in my company we ran a “game” the night before the election, where the prize was a free dinner for anyone who got both the winner and the direction of the market right. The wisdom of our little “crowd” got both the winner and the consequences (a sharp rise in stocks) right on average. And one person in particular made it and won the free dinner.

The outcome of the election and market performance make the job of Jay Powell and the FOMC meeting today much more difficult. From my perspective, the last cut of 50 basis points in light of a strong economy and booming market was probably a “political” move and not necessary given economic conditions. All in all, it had the potential to tilt the electoral odds against the incumbent party, since a booming stock market makes voters more likely to be in a positive frame of mind when they go to the polls or cast their ballots. The stock market rallied after the previous big rate cut, even in the face of a sharp selloff in the bond market that basically cushioned the Fed’s actions. Yields have risen close to 0.75% since the 0.50% cut, showing what the market thinks about the actions. It was a vote by the bond watchers that the cut was neither required nor appreciated in light of economic conditions. But the Fed works to manage and deliver on the expectations it creates, and the expectations were managed against the big cut, and therefore had to be delivered, regardless of market and economic conditions.

Which brings me to the decision today. Again, there is no reason to cut today as the stock market has reached record highs, there is euphoria in the markets and the economy is doing well. But disappointing the market by not cutting would go against the expectations the Fed has built into asset pricing. On the other hand, the election results are already out – there is nothing political to gain right now. The last move did not help the incumbent party. A political Fed, if this theory is correct, will keep its powder dry, so to speak, as a gift to the incoming president, who will likely be appeased by a big cut right after taking office. In other words, game theory as applied to the Fed suggests that the Fed will delay its expected 0.25% cut today, and possibly again as expected at the December meeting, and deliver a super-sized cut after the inauguration. Postponing the cut will not only allow the Fed to use rational economic logic, but also buy itself some bonus points from a manager who wants the Fed to be aggressive in cutting interest rates at his direction. It’s a win-win, and thus the path of least resistance. Quite logical, actually. As for disappointing the markets — not that it takes the Fed’s decisions into account — does it actually matter now that stocks are at record highs? And not cutting today can actually calm the bond market, which in the long run can be good for, among other things, the deficit.

I am quite aware that skeptics of the logic above will react to my forecasts as being overly simplistic and skeptical. There will certainly be backlash to the idea that the Fed and Jay Powell are making decisions that are politically motivated. Yes, that’s not how it “should” be, but unfortunately that’s how it is. With a series of bad economic calls and bets over the past five years, the Fed’s independence is at risk. The results of the election have made this an existential question, so I suspect the Fed will play the game that gives it the best chance to survive under the new president. And it also makes economic sense.