Bonds and stocks rallied in response to Fed chair Jerome Powell’s August 23 signaling that the time has come to reverse course and begin lowering interest rates.
But commentators on economic affairs weren’t unanimous in hailing the pending rate cuts as good news. For instance, The Credit Strategist wrote: “Powell promised to keep debauching the dollar by lowering interest rates in September when there is no need to do so.”
Nor was it clear that reducing the fed funds rate would have the desired effect. According to Amara Omeokwe and Jonnelle Marte of Bloomberg Editorial:
After being late to raise rates in response to an inflation surge during the Covid-19 pandemic, Powell’s remarks underscore how Fed officials are hoping to avoid another policy error now that price growth is easing. Their success or failure will determine whether there’s a so-called soft landing, the rare feat of smothering a burst of inflation without tipping the economy into recession.
How can different experts, looking at the same facts, disagree about the appropriateness of the Fed’s response and express doubt about whether it will achieve the desired result?
Economics versus Hard Science
Those indications of uncertainty underscore a point that should be emphasized more often than it is. “Managing the economy” is not an exercise in hard science. Don’t be fooled by pundits who defend their positions by suggesting that when monetary or fiscal authorities intervene in the economy, A inexorably leads to B.
That sort of cause-and-effect predictability is much more defensible in other kinds of human interventions. Take, for example, applying sunscreen. A scholarly article of 2022 lists the factors that produce the desired effect, i.e., preventing sunburn and other harmful effects of exposure to sunlight:
The effectiveness of sun protection depends directly on the photo-protective product employed, the way it is used and the amount applied…Factors influencing effectiveness include sun exposure conditions (direct or indirect), level of protection (SPF), amount of product applied, maximum exposure period before reapplication, product type (spray, lotion, etc.), layer thickness required, coverage, and ability to spread and permeate into the skin.
This tells us that the experts in dermatology and pharmaceuticals who authored the article were able to identify the variables that determine whether the intervention will succeed. If the sunscreen user follows proper procedures such as applying it before going outdoors, waiting 15 minutes to let the skin absorb it, and using about one ounce, the desired effect will reliably be realized. (For further details, see this advisory from the American Academy of Dermatology.)
Many more variables determine the impact of a cut or hike in the fed funds rate and not all of them are identifiable. Because Fed policy famously operates with long lags, it may not even be feasible to establish with certainty, after the fact, precisely what the impact was. Other economic forces will have entered the mix in the interim.
In this light, the concept of a policy error is questionable. If the Fed could not have known exactly what the result of its actions would be, what does it mean to say that an undesirable outcome proceeded from a mistake? It’s very different from blaming sun-related damage on a failure to apply lip balm along with the sunscreen.
Investment Implications
What this all means for investors is that speculating on the future direction of stock or bond prices on the basis of the central bank’s interest rate policy is a dubious enterprise. Those bets can backfire not only by getting the Fed’s next move wrong, but also by getting it right but making a wrong assumption about its consequences.
Investing’s closest things to the vastly greater predictability found in the hard sciences are such principles as prudent diversification and taking a long view. Avoiding fads and considering valuation in making new investments also stand the investor in good stead. On the other hand, aggressively trading on short-run market events is likely to detract from the returns achievable through a steady hand on the wheel.
