The Federal Reserve seems to be at the center of every major economic issue in the world today. Currency wars are said to be driven by the Fed and other central banks cutting rates. The Fed is also trying to cut rates to stimulate growth in the face of trade wars.
The new Fed policy of rate cuts has also triggered rallies in stocks, bonds and gold. Oil rallies when the Fed cuts rates and vice versa. Everywhere you turn, Fed policies and expected policies are the drivers of sharp moves in almost every asset class from physical commodities to derivatives.
The Fed’s impact on markets is undeniable, but what drives the Fed itself? At its base, the Fed is caught in an impossible conundrum. On the one hand, the Fed needs to raise rates and reduce its balance sheet in order to prepare for rate cuts and possible QE in the next recession. On the other hand, the process of raising rates and reducing the balance sheet can cause the recession the Fed is preparing to cure.
The Fed nearly caused a recession in late 2018 after four rate hikes and massive balance sheet reduction that year. The Fed then did an about-face with rate cuts and an end to balance sheet reduction this year. What forces are driving the Fed as it contemplates its next move?
Those forces are neatly summarized in this article. Those forces are: an inverted yield curve (which has historically been a recession signal); declining manufacturing output in the U.S.; political uncertainty in Europe; a strong yen; and declining global growth, especially in China. All of these factors (except the strong yen) point toward more rate cuts even though the Fed would like to raise rates in anticipation of the next recession.
The Fed should recall the Rolling Stones lyric “You can’t always get what you want.” Meanwhile the Fed’s conundrum continues with no end in sight.
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