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The Real Problem With Fed Rate Cuts

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The Real Problem With Fed Rate Cuts

If you’ve never heard of a “Liquidity Trap,” this is a great time to learn

Part of my long-term professional mission is to mentor aspiring investment pros. I try to teach them the ins and outs of research and money management. Thus, each summer my firm is well-stocked with investment interns. They are typically in college or have recently graduated.

Last week, one intern (who happens to be my son) reported on the possibility that a Fed rate cut could backfire. That is, the Fed can lower interest rates, but unless it sparks an increase in spending by consumers and businesses, it doesn’t do much good. There is reason to believe that with rates already quite low, this could happen. So, instead of pushing the “accelerate” button on the economy, the Fed could merely be pushing on a string.

The interns report to me on different aspects of the financial and economic news. It is part of a training program I created several years ago. From time to time, they bring an idea that prompts me to write about it here.

Brace yourself!

Brace yourself for this possibility. After all, there is plenty of precedent for the stock market to rally before and right after a Fed rate cut. However, what happens after that initial “pop” (if it occurs at all) is what matters to all but the most nimble traders. Sure, rate cut increases potential economic “liquidity.” However, if that can’t be soaked up because consumers are tapped out after years of spending borrowed money, that liquidity doesn’t make a difference. This is what is called a “liquidity trap.”

I wrote recently that the stock market does not react favorably to rate cuts. Specifically for the S&P 500 Index, the aftermath of the last 2 rate cut cycles looked like this:

Is the U.S. turning Japanese?

The phrase “liquidity trap” has not entered my mind for years. So, let me explain it a bit further. Japan went from an economic wonder of the world in the 1980s, to 30 years lost in the stock market desert. That is, Japan started the 1990s with GDP growth over 3%, and interest rates at 6%. Next, stock prices fell and inflation went to 0% by 1995, and interest rates hovered around 2%.

In response, Japan’s central bank reduced interest rates to 0%, but this failed to address the deflation as well as stagnation in GDP growth, putting the Japanese economy in a liquidity trap. Here is what has happened to Japan’s stock market since the mid-1990s. That’s a total return of about 8%. To be clear, that is not 8% per year. It is 8% over 24 years!

A people problem

Why should today’s investors in the U.S. care about what happened to Japan 30 years ago? Because the conditions are similar. Interest rates currently low and in danger of going lower. Furthermore, like Japan back then, we have a growing demographic problem. There is a huge generation of retiring Baby Boomers who are on the government payroll (Social Security, Medicare, etc.). A failed attempt to stimulate further economic growth would only add to that problem.

Thanks to Tyler Isbitts for his research assistance on this article

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