The inescapable signal of a Fed rate cut

The Federal Reserve maintains a consistent, albeit uncomfortable, doctrine: it does not cut the short-term Federal Funds Rate into a demonstrably strong economy. An easing of monetary policy is fundamentally at odds with an environment characterized by robust GDP growth, tight labor markets, and persistent inflationary pressures. When the economy is performing optimally, the central bank’s primary concern remains stability and price control, necessitating a neutral or restrictive stance. Therefore, the first rate cut following a significant tightening cycle should never be viewed as a reward for economic strength. Instead, it is a signal—a tacit admission by the Federal Open Market Committee (FOMC) that the prior restrictive policy has finally slowed demand sufficiently, and that the underlying economic momentum is beginning to stall. It is the central bank acknowledging that the risk has officially shifted from inflation to unemployment and contraction.

This critical signaling function leads directly to the next point: for each quarter-point reduction, the statistical probability of a recession in the very near future noticeably increases. A 25-basis point cut is rarely a pre-emptive, surgical strike; it is often a reactive measure taken when leading indicators, or even coincident data, begin to seriously falter. The Fed is not merely easing; it is attempting to manage a deterioration that has already begun. The deeper the central bank is forced to cut—moving from an initial 'insurance' cut to a pattern of successive, reactive cuts—the more apparent it becomes that the economic ailment is severe. These incremental reductions, therefore, function less as instant stimulus and more as a lagging indicator of accelerating risk, confirming that the central bank’s restrictive measures finally broke something critical in the economic engine.

History offers a chilling confirmation of this pattern, which holds true almost all the time. Since the early 1970s, nearly every significant Fed easing cycle that followed a sustained period of rate hikes has culminated in, or immediately preceded, a recession. The initial cuts that mark the beginning of an aggressive easing phase are typically followed by a full-blown economic downturn within the subsequent 12 to 18 months. While policymakers and commentators occasionally dream of achieving a perfect 'soft landing,' the data suggests that once the Fed has tightened enough to necessitate a decisive pivot to cutting, the underlying damage is already done, and the recessionary forces have been unleashed. Prudent investors must view the commencement of a rate-cutting cycle not as a cause for celebration, but as a definitive, high-confidence warning sign that the economy is transitioning into a high-risk phase.

The recent negative GDP growth figure was revised down to -1.6%

As it turned out, the negative GDP growth figure mentioned in our last post was revised down to -1.6%, from -1.5%. This is related to our recent post on the Atlanta Fed. From Tradingeconomics.com:

  

"The American economy contracted an annualized 1.6% on quarter in Q1 2022, slightly worse than a 1.5% drop in the second estimate. It is the first contraction since the pandemic-induced recession in 2020 as record trade deficits, supply constraints, worker shortages and high inflation weigh. Imports surged more than anticipated (18.9% vs 18.3% in the second estimate), led by nonfood and nonautomotive consumer goods and exports dropped less (-4.8% vs -5.4%). Also, consumer spending growth was revised lower (1.8% vs 3.1%), as an increase in spending on services, led by housing and utilities was partly offset by a decrease in spending on goods, namely groceries and gasoline. Meanwhile, private inventories subtracted 0.35 percentage points from growth, much less than a 1.09 percentage points drag in the second estimate. Fixed investment growth remained robust (7.4%) but housing investment was subdued (0.4%, the same as in the second estimate)."

Is the Atlanta Fed predicting an imminent recession?

Has the US been funding economic growth with debt?

Summary

- Since the Great Recession real economic growth seems to be largely funded by debt in the US.

- One could argue that the US has a robust economy, so the government can keep on borrowing for several more years, and then simply print money to pay for some of that debt.

- The problem with this approach is that it would could lead to a devaluation of the US dollar, and thus an increase in inflation in the US.

- The bottom line is that the US must reduce its federal debt.

Federal surplus and GDP growth in the US from 1950 to 2018

The graphs below are for the period going from early 1950 to late 2018, and were generated using the US Federal Reserve Economic Data (FRED). This publicly available web resource combines access to an extensive database of world economic data with very nice graphing features (see: ).

The graph at the top shows the federal surplus rate as a percentage of the real gross domestic product (GDP) in the US for the 1950-2018 period. Values below the line indicate negative surpluses, or deficits. The graph at the bottom shows the real growth in GDP in the US for the 1950-2018 period. It is called “real” growth, because it is corrected for inflation.

The difference between GDP growth and federal surplus

Has the US been funding economic growth via federal deficits? Let us see. The graph below shows the difference between the real growth in GDP and the federal surplus rate. Values below the line are for periods in which the US is essentially funding GDP growth through issuance of debt, primarily in the form of treasuries (bills, notes, and bonds), a debt that tends to accumulate over time.

As you can see, since the Great Recession () we have been seeing quite an interesting and unique pattern in the US. Except for a small period of time around 2015, real economic growth seems to be largely funded by debt. The extent to which this has been happening has not been seen since 1950.

Generally speaking, income from taxation gravitates around 17 percent of GDP. This happens, contrary to popular belief, almost regardless of taxation levels. Therefore, GDP growth should lead to a reduction, not an increase, in the federal deficit – since deficits occur when the government spends more than it takes in as income from taxation. The largest proportion of government expenses come from retirement benefits; which grow as the population becomes older.

The danger of inflation

So, what is the big deal? One could argue that the US has a robust economy, so the government can keep on borrowing for several more years, and then simply print money to pay for some of that debt. After all, the amount of US currency in circulation has been steadily increasing over the years ().

The problem with this approach is that it would could lead to a devaluation of the US dollar, and thus an increase in inflation in the US, because an increase in the supply of anything (including money) tends to lead to its devaluation if demand does not increase at the same pace.

Here is a simple analogy. If you lend money to John Doe (JD) in return for JD dollars, and then JD issues more JD dollars to borrow from someone else, you will probably be concerned and want to exchange your JD dollars for something else. For example, you may want to exchange them for Jane Smith (JS) dollars, assuming that JS owes less debt as a percentage of her income than JD.

Generally speaking, that may be the fate of the US dollar, if the federal debt keeps on growing. The US dollar will lose value, leading to inflation, if other currencies or stores of value (e.g., gold) are given preference over the US dollar.

The bottom line is that the US must reduce its federal debt. How can this be done? Increasing taxation levels is unlikely to be a viable solution, as income from taxation gravitates around 17 percent of GDP; as noted earlier, almost regardless of taxation levels.

One possible solution is to significantly increase skill-based immigration of young workers, thus reducing the number of retirees as a percentage of the overall US population. The US is in an enviable position in this respect, as there are many skilled professionals willing to live and work in the US.