Whether the Fed’s rate cuts can achieve a soft landing depends not only on how much slack there is within the U.S. economy, but also on whether lower borrowing costs can spur new investment and spending to offset any slowdown.
Fed Chairman Jerome Powell's move to cut interest rates by 50 basis points last week was seen as a "show of strength" as he reiterated the Fed's desire to avoid having to make larger rate cuts later if the economy weakens. "We don't think we're behind," Powell said at a news conference. "You can think of this as a signal of our commitment not to fall behind."
Achieving a soft landing - reducing inflation to the Fed’s 2% target without a significant deterioration in the labor market - could still be tricky because it ultimately requires new loan growth. Bank loan growth has slowed to a crawl over the past year, a phenomenon typically seen only during recessions.
Even if interest rates fall, many businesses and households may still be reluctant to borrow because they will face higher interest rates than they currently pay on fixed-rate loans, which were locked in several years ago. If these borrowers or businesses are reluctant to obtain new loans, rate cuts may do little to boost the economy.
The problem is the difference between the marginal cost of debt, which is currently falling, and the average debt interest rate, which is likely to continue to rise, especially for borrowers who locked in low rates before the Fed started raising rates. Because the Fed has been raising rates so quickly after more than a decade of unprecedented low borrowing costs, the average debt interest rate in many industries remains below the marginal cost of new credit, even as the Fed is cutting rates.
“The relief from rate cuts is not obvious because the average interest rate faced by households and businesses will rise even if the Fed cuts,” said Peter Berezin, chief global strategist at BCA Research.
Is demand surging or just a trickle?
Weak housing demand over the past year suggests borrowers are doing everything they can to avoid higher interest rates. In this rate hike cycle, they are choosing not to move.
The interest rate on a 30-year fixed-rate mortgage fell to less than 6.1% last week, the lowest level in two years, according to Fannie Mae, up from 7.2% in May. But the interest rate on the average outstanding mortgage was 3.9% in July, according to loan-level data from Intercontinental Exchange Inc. That rate has barely budged in the past two years because many Americans have long-term fixed-rate mortgages.
In addition, so far, lower interest rates have failed to effectively boost Americans' housing affordability, which is at a historically low level. "The easing policy has not yet brought about a clear surge in demand," said Jody Kahn, senior vice president of John Burns Research and Consulting. A recent survey of 50 home builders showed a slight increase in website traffic, "but overall, people are very mixed about whether website traffic has increased due to lower mortgage rates."
The Fed cut its short-term benchmark interest rate by 50 basis points last week to a range of 4.75% to 5%. Most officials expect another 50 basis point cut by the end of December, which would take the benchmark rate to a range of 4.25% to 4.5%.
For debt maturing in the next year, corporate borrowers with lower fixed-rate loans could still face a sharp rise in borrowing costs even if the Federal Reserve cuts interest rates by a full percentage point this year. Companies with long-term fixed debt "don't need to do anything right now, so they're not going to change their decision-making activities in the short term," said Rebecca Patterson, former chief investment strategist at Bridgewater Associates.
To be sure, investors are optimistic because the Federal Reserve has plenty of room to cut interest rates. Lower rates would boost sentiment, including by signaling the Fed will move more quickly to cushion the economy if weakness emerges.
In addition, some smaller and riskier companies whose debt is floating rate debt and bank loans will get an immediate reprieve from the Fed's rate cut. More importantly, lower US interest rates may lead to a weaker dollar, allowing emerging market economies to cut interest rates without worrying about currency depreciation.
The Fed’s Risks
Still, there is a risk that the Fed’s current easing cycle could face similar challenges in transmission to the broader economy as the Fed’s recent rate hike cycle did. Two years ago, when the Fed raised rates by 75 basis points, analysts were increasingly surprised by the economy’s remarkable resistance to higher funding costs.
Many households and businesses have proven resilient because they locked in low borrowing costs on fixed terms when interest rates fell to extremely low levels in 2020 and 2021.
“The rate-hike cycle has been met with the fact that we’ve just given a lot of companies and households a lot of cash buffers, which means they don’t need to borrow, and that really weakens the transmission of policy,” said Esther George, a former president of the Kansas City Fed. She said whether that “will also happen in a rate-cutting process” is an unknown.
Jon Faust, who served as a senior adviser to Powell from 2018 until earlier this year, said central bankers have to accept that they know very little about how monetary policy is transmitted to the broader economy. “The specifics of ‘when’ and ‘how hard’ really depend on the economy, and a lot of that depends on things that we can’t control,” he said.
Some business owners were wary of last week’s rate cut. Even if rates were lowered by a full percentage point, “it wouldn’t have much of an effect because we’re still coming down from pretty high rates,” said Elias Sabo, chief executive of Compass Diversified, a private equity firm that owns midsize businesses.
Sabo said the company has seen continued weakness in consumer demand over the past year, with a sharp drop between the first and second quarters before easing in the third quarter.
“Everybody is seeing this, no matter where you operate,” Sabo said. At the beginning of the year, his company’s job openings reflected the difficulty in recruiting qualified candidates. Now, he said, his company is slowing hiring and intentionally leaving positions unfilled because demand has cooled.
Few industries illustrate this dynamic better than real estate. The transition from a period of historically low interest rates to a period of ultra-low interest rates and then the highest rates in two decades during the coronavirus pandemic was particularly confusing for the commercial real estate industry. “There was a lot of buying and selling activity, and then there was a sharp slowdown on the other side,” said Tedd Friedman, a commercial real estate attorney in Cincinnati.
Many homeowners with low-interest debt are waiting for the last minute to refinance, hoping the Federal Reserve will slash interest rates by then. Many regional banks have “quite thick balance sheets and a lot of challenged assets on their balance sheets,” making lenders reluctant to refinance non-existing customers, Friedman said.
He expects loan defaults to rise steadily unless interest rates fall significantly over the next year, as refinancing becomes more expensive for property owners. “These assets are doing pretty well until they need to be refinanced,” he said.
The article is forwarded from: Jinshi Data
