Following the US Federal Reserve’s September rate cut, labor data may have more impact on markets than further cuts. Andrew Sheets, Head of Corporate Credit Research, explains why.
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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll discuss why what the Fed does next might not matter all that much.
It’s Friday, October 4th, at 2 pm in London.
Over recent months the Federal Reserve has been at the center of the global market debate. After keeping policy rates unchanged at the end of July, a decision the markets initially cheered, a string of weak data in early August drove concerns that Fed policy was behind schedule. The Fed then responded with a larger-than-expected half-percent interest rate cut in September. And so, given these swings, a common question for investors is, understandably: What will the Fed do next?
But what if the Fed’s next move doesn’t matter all that much?
Monetary policy is both powerful and weak. Powerful, because interest rates impact so many decisions across the economy, from buying a home, to financing equipment, to acquiring a competitor. And it’s also weak, because how interest rates impact these decisions can have a long and variable lag. It can be six to twelve months before the full impact of an interest rate cut is felt in the economy. And so that half percentage point cut by the Fed last month might not be fully felt in the US economy until June of 2025.
That lag is one reason why the Fed’s next move may matter less. The second reason is what we think the market is worried about. We think a lot of the market’s volatility over the last two months has been driven by concerns that the US economy, particularly the labor market, is weakening right now.
If interest rates are too high and the labor market is weakening, then cutting more rapidly in the coming months might not make a difference. Because of that lag, the help from lower rates simply wouldn’t arrive in time.
Meanwhile, there’s also a view that interest rates might need to fall quite a long ways to have the sort of impact that would be needed if the economy is really slowing down rapidly: by the Fed’s own Summary of Economic Projections (SEP), the policy rate that neither helps or hinders the economy could still be about 2 per cent lower than the current rate – even after that half a percentage point cut in September. Interest rates are well above what could be neutral.
In short, if the data weaken materially over the coming months, more Fed cuts may not necessarily help in time. And if the data remain solid, Fed policy will have lots of time to adjust. It’s the data, not the Fed’s next action, that are most important at the moment.
We also see support for this idea in history. It’s notable that some of the most aggressive US interest rate-cutting cycles – 2001, 2008, February of 2020 – overlapped with weak equity and credit markets. And it was smaller rate cutting cycles – in 1995-96, 1998 or 2019 – that overlapped with much better markets. And that makes sense; if one assumes that it’s the data rather than exactly how much the Fed is cutting rates that matter most to the market.
All of this especially feels topical today. Today’s better than expected report on the US jobs market should support the case that Fed policy is on schedule, and larger adjustments aren’t needed. It’s good news.
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