Why the Fed shouldn’t and probably won’t cut interest rates today

It was an eventful week, with an election for the ages. What really struck me was how wrong the pollsters were and how right the prediction markets were. Yes, in the later days of the race there were rumors (mainly from pollsters) that the prediction markets may have been manipulated. Looking back, this theory didn’t pan out. It should come as no surprise that when investors are “in the game,” they tend to make better predictions overall, since the reward for being right is a win, not just a tick on the reputation chart. In other words: you are part of the game. As an investor, it is not just enough to be right, it is also important to correctly draw the consequences in real time.

As with every previous election, we at my company held a “game” the night before the election where the prize was a free dinner for anyone who correctly identified both the winner and the direction of the market. The wisdom of our small “crowd” has, on average, correctly identified both the winner and the consequences (a strong stock rally). And one person in particular did it and won the free dinner.

The election outcome and market developments make the task of Jay Powell and today’s FOMC meeting much more difficult. In my view, given a strong economy and a booming market, the latest 50 basis point cut was probably a “political” move and not necessary given the economic conditions. Overall, it had the potential to tip the electoral odds in favor of the incumbent party, as a booming stock market increases the likelihood that voters will be in a positive mood when they go to the polls or mail in their ballots. The stock market rallied after the previous big rate cut, even in the face of a sharp selloff in the bond market that essentially wiped out the Fed’s actions. Yields have risen almost 0.75% since the 0.50% cut, showing what the market thinks about the measures. This was a vote by the bond watchdogs that the cut was neither necessary nor welcomed given the economic situation. But the Fed is working to manage and meet the expectations it created, and the expectations were steered toward deep cuts and therefore had to be met, regardless of market and economic conditions.

Which brings me to my decision today. Even today there is no need for savings because the stock market has reached record highs, the markets are euphoric and the economy is doing well. But disappointing the market by not cutting interest rates would be at odds with the expectations the Fed has built into asset pricing. On the other hand, the election results are already in – there is currently nothing to be gained politically. The latest move did not help the incumbent party. A political Fed, if this theory is correct, will keep its powder dry, so to speak, as a gift to the new president, who will likely be appeased with a big cut immediately after taking office. In other words, game theory as applied to the Fed suggests that the Fed will hold off on its expected 0.25% rate cut today, and perhaps again as expected for the December meeting, and make an outsized rate cut after Inauguration . Delaying the rate cut will not only allow the Fed to apply rational economic logic, but also earn itself some bonus points from a leader who wants the Fed to aggressively cut rates at his direction. It’s a win-win situation and therefore the path of least resistance. Actually quite logical. As for market disappointment – not factoring it into Fed decisions – does that even matter now that stocks are hitting record highs? And if interest rates aren’t cut today, the bond market could actually calm down, which could have a positive impact on the deficit in the long run, among other things.

I am fully aware that skeptics of the above logic will view my predictions as overly simplistic and skeptical. Certainly the idea that the Fed and Jay Powell are making politically motivated decisions will be met with resistance. Yes, that’s not how it “should” be, but unfortunately it is. Given a series of bad economic forecasts and bets over the past five years, the Fed’s independence is at risk. The election results have made this an existential problem, so I suspect the Fed will play the game that gives it the best chance of survival under the new president. And it also makes economic sense.