A "pause" in the financial markets makes the reduction of Fed rates less likely

WASHINGTON / NEW YORK (Reuters) – Risk taking has been in fashion since the Federal Reserve stopped raising interest rates late last year. US stocks have almost bottomed out and investors are stocking the weakest corporate bonds with only a small additional compensation for increased risk.

A president who calls for a Fed rate cut after the sharp fall in markets last year could welcome the bumpy atmosphere on Wall Street and complain that even stopping at the current level is a bad choice.

But in reality, the Wall Street "break party" makes it even less likely that the US central bank will cut rates. Recent positive news regarding retail sales and exports, which eased fears of a marked slowdown in the economy, argue for even lower rate cuts.

Investors at least have understood the message and no longer expected a reduction in interest rates later in the year but a 50% to 50% probability that the Fed will fall in early 2020.

Wall Street celebrates the "pause" of the Fed

According to some analysts, the state of the financial markets is proof that last year's Fed rate hikes were good, which allowed the economy to continue growing while controlling risks. A rate reduction at this stage would only cause problems.

"The reason they should keep the possibility of a rate hike on the table is due to financial stability," Citi chief economist Catherine Mann told reporters on Wednesday. a conference on financial stability at the Levy Economics Institute of Bard College.

After a decade of interest rates close to zero, "it is essential to move to a risk-priced asset price constellation to achieve a more stable financial market," she said. noting that stock prices and low-quality bond yields were showing a market this is still too optimistic.

In their criticism of the Fed, US President Donald Trump, White House chief economics advisor Larry Kudlow, and proposed Fed candidate Stephen Moore said a rate cut would allow for growth. faster and would be consistent with Trump's economic plans. They argue that, with the risk of low inflation, the central bank does not need to maintain an "insurance" against it by keeping its key rates where they are.

In this analysis, concerns about financial stability that have been consistently embedded in the Fed's policy making since the 2007-2009 financial crisis have been neglected. Mr. Mann spoke at a conference named in honor of economist Hyman Minsky, who explored how the financial surplus can be built during times of prosperity and relax catastrophically. The economic slowdown observed a decade ago showed how much this dynamic could deeply scare the real economy.

Financial stability is not a formal mandate of the Fed, which, under congressional legislation, is supposed to maintain the twin goals of maximum employment and stable prices. However, since the crisis, the central bank has concluded that it was essential to keep the financial markets on a solid base to achieve the other two goals.

This does not mean the end of volatility or the guarantee of profits, but rather that the risks are correctly assessed and that the use of leverage – investments made with borrowed money – is kept within safe limits.

Keep an eye on stock valuations

This is one of the main reasons why even policymakers eager to maintain high employment rates, such as Boston Fed President Eric Rosengren, have sometimes adopted a hawkish stance in favor of higher interest rates. . According to Rosengren and others, the worst result for the workers would be to let the markets inflate too much and collapse again, even though this implied a slightly higher risk of unemployment in the meantime.

Markets are currently "a bit rich," Rosengren said in a recent speech at Davidson College in North Carolina.

Although this is not enough to justify a rate increase, he said, it goes against a rate cut. On the whole, Fed officials, including President Jerome Powell, said they felt the financial risks were within a reasonable range, which policymakers said was favored by rate increases. nowadays.

The state of the financial markets is "a problem with which the Fed must fight," said Rosengren. "It is appropriate that interest rates be suspended now."

Corporate bond valuations look foamy