The summer I graduated from high school, a Swedish rock band named Europe released a song called “The Final Countdown.” This was seriously silly stuff about a spaceship taking the group to Venus, hoping the locals there are friendly and acknowledging the many light years it will take to get there. Both the song and its accompanying music video deserved all of the derision it received.
Why silly? First off, Venus’ surface temperature (800+ degrees Fahrenheit) and atmosphere (96.5% carbon dioxide) can’t support life as we know it. Secondly, as a result, it is highly doubtful there would be any locals there to greet the guys. Finally, it doesn’t take light years to get to Venus, only about 4 minutes at the speed of light.
However, the song was still a worldwide smash hit, and the guys in the group have been laughing all the way to the bank since. What’s more, the opening keyboard track to the song has been rolling around in my head all morning long. If you know, you know.
You see, after 24 months of discussing and speculating about the timing of an initial Fed rate cut, we will likely get one next Wednesday. By likely, it is as close to a certainty as you can possibility get. The only things more certain than a rate cut next week are death, taxes, a sale at Jos. A. Bank and the lack of a Venusian greeting committee for Swedish musicians.
Confused where this is going? Well, let’s just say we are in the final countdown, finally.
But, why has it taken so long to get here? I mean, while the official economic data has been pretty decent, neither inflation nor economic activity have appeared to be in danger of “overheating” for quite some time now. Shoot, you could even argue we have been on a slow, slightly negative slope since the money supply (M2) stopped growing in April 2022.
Interestingly enough, the 12-month Consumer Price Index (CPI) peaked, for this cycle, a couple of months later in June. Hmm. Perhaps Milton Friedman was right about inflation being a monetary phenomenon. When the supply of money in the economy stops going up, prices start coming down.
Makes sense. But will or could a rate cut potentially stimulate lending, boosting M2 and causing inflation to rise again? If so, just how aggressive should the Fed be in cutting the overnight rate? If very, will it lead to inflation, which has been killing the U.S. consumer? Especially those in the lower income quartiles, for the last several years?
Okay. I have about 600-700 words remaining to explain some pretty arcane topics. This should be fun.
When the Federal Reserve lowers the overnight lending target rate, banks will eventually reduce what they pay depositors. This reduces their cost of funds, and should improve the “net interest margin (NIM)” on their overall loan portfolio. NIM is the difference between the rate(s) where banks borrow money and where they can lend it. Obviously, the bigger the difference, the better it is for the firm.
In a falling interest rate environment, they will try to make “fixed rate loans” with a longer time until maturity. Conversely, in a rising interest rate environment, they will try to make “floating rate loans” with a shorter time until maturity. Basically, the lender will try to maximize the interest rate it charges over the entire rate of the loan.
Now, when banks make loans, they increase the money supply, almost as though out of thin air. They borrow the money from a deposit and lend it to a borrower. However, the depositor still has access to their money. Essentially, both have the ability to spend the same dollar. If this doesn’t make sense, do you remember the scene in “It’s A Wonderful Life” where there is a run on the Bailey Building & Loan? If so, you might remember the following quote from George Bailey:
Believe it or not, that is one of the more accurate statements about the financial system to ever come out of Hollywood. Go figure.
So, if lower deposit costs for banks induces them to make more loans, particularly fixed rate ones, there could, indeed, be an increase in the money supply.
Since borrowers tend to spend their loan proceeds pretty quickly, the more loans banks make, the more money will move about the economy. If the depositor decides to spend their money as well, even more cash will be “out there” chasing after a relatively finite amount of goods & services.
Historically, when this happens, prices tend to go up. It is basic economics, really. When the supply of something increases, its value will decrease unless there is a commensurate increase in demand. Since most people don’t drain their checking/money market account to $0 every day, the increase in the supply of money when a bank makes a loan is greater than the demand for it (for consumption purposes). As such, the value of the money will go down….even if ever so slightly.
When this happens, the seller of goods & services will demand more dollars for their wares. After all, the value of their work hasn’t changed, just the number of currency units it will take to sate it. I hope that makes sense. If it doesn’t, consider this analogy:
Image a kid wants to make enough money to buy a $100 bicycle by selling lemonade at $1/cup. Now, what would happen if prices, across the board, were to go up 50%? Would they continue to sell their lemonade for $1, which would, obviously, require them to sell a lot more lemonade? Or would they try to increase what they charge by 50% as well?
I think the answer is obvious. The value of the work here was the bicycle. The money was just a means to the end.
If you have read this far and followed the last several hundred words, you can hopefully appreciate why the Fed has historically been, and will likely continue to be, painfully gradual in making changes to monetary policy. Being either too cautious or too aggressive can have dramatic ramifications for the economy and inflation.
Besides, and this is where the rubber meets the road, the voting members on the policy making arm of the Federal Reserve, the Federal Open Market Committee (FOMC), are mostly academics. Hey, there is absolutely nothing wrong with that. Shoot, in a lot of ways it would be awesome.
However, this sort of worker/person will likely have a different/lower risk tolerance than movers & shakers in the private sector…you know, the Elon Musk’s of the world. They, the former, likely find greater comfort in consistency and process than the thrill in chance and vision.
Think about it. What does any individual member of the FOMC have to gain by decreasing the overnight rate by 100 basis points next week? Seriously, what? At least ethically and legally? Nothing, or as close to nothing as you can get. Quick…name me the President of the Cleveland Fed when the Fed embarked on an easing cycle in September 2007. Catch my drift?
As a result, the path of least resistance is to “count on” a 25 basis point rate cut next week, and be pleasantly surprised by anything greater than that. You can think of it as going to the track, and betting on the horse with the lowest odds to “show.”
Unfortunately, I have already used more than my self-imposed word count here today. Perhaps there will be more on this topic next week, hopefully after a nice fat rate cut.
Hey, it’s the Final Countdown.
Have a great weekend.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this and every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as well as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.