Pushing on a String By: Gabriel PotterMBA, AIFA® 2019.07.31

The Federal Reserve is about to cut the interest rates.  We’ve spent a lot of time debating the justification for cutting interest rates (e.g. below target inflation) and we’ve considered the long term dangers of cutting rates (e.g. reduced credibility in the Fed’s political independence and responses to actual economic threats).  We haven’t actually spent a lot of time talking about the efficacy of such a move. 

Will cutting rates even work?  It depends on what you’re trying to accomplish.  What do you want cutting rates to do?  It sends a crystal clear signal that monetary policy will hedge against market downturns, even in the absence of fundamental economic data.  Certainly that’s what the administration is hoping for. If you promise easy money to prop up the stock market in the short to medium term, it may very well succeed.

Do you want cutting rates to increase economic activity?  There’s a good argument for that as well.  Cutting rates essentially lowers the costs for borrowing money.  That increases in-hand pocket money for certain mortgage holders, which could boost spending.  It allows businesses and consumers to borrow more easily, increasing the potential for new investment.  Also, it changes the medium-to-long term calculus behind certain projects, pushing the net-present-value calculations for marginal business proposals into the black.

However, let’s take the theoretical argument for cutting rates out of the classroom and into reality.  In today’s reality, businesses are already flush with cash.  Despite having lots of on-hand cash, one thing they are *NOT* doing is investing it into projects.  This lack of corporate action was a very notable red-flag in last week’s (otherwise rosy) 2Q GDP estimate.  Consumer spending, already expansive, could get a boost in optimism, but counting on institutional activity may beggar credibility.

If you’re looking at a readily available pile of money and favorable existing economic conditions, then throwing more money onto the pile isn’t necessarily going to change behavior.  We may have reached a limit of monetary policy to influence corporate direction.  The classic analogy for this conundrum (which Investopedia attributes to famed economist J.M. Keynes) is that we’re “pushing on a string”.

 

 

 

 

 

 

 

 

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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