"Blunt" Interest Rates Raise Doubts About Fed's Easing Effectiveness

If the steep interest rate hikes over the past two years had little effect in slowing the US economy, it's worth questioning whether reversing these rates will have much impact in a downturn.

One of the perplexing observations over the past two years has been how the Federal Reserve's (Fed) rate hikes — totaling five percentage points between March 2022 and July 2023 — have done little to dampen overall economic activity. Despite the higher borrowing costs, US real gross domestic product (GDP) has maintained annualized growth rates above 2% in seven out of eight quarters since mid-2022 and is set to continue this trend through the end of September.

Additionally, the stock market remains near record highs, suggesting that the economy may have become less sensitive to changes in short-term borrowing costs. If this trend holds, policymakers could face challenges if a future slowdown — or even a cyclical recession — proves similarly resistant to monetary policy easing.

Why the Economy Is Resilient to High Rates

Several theories explain this resilience to high rates: the unique circumstances of the Covid-19 pandemic, which included ample household savings and government spending; the prevalence of fixed-rate debt in the US, particularly in mortgages; and elevated corporate cash levels, which more than offset the impact of higher debt servicing costs on small firms.

Remarkably, net interest payments by US firms as a share of GDP were halved during the tightening cycle, according to the International Monetary Fund. Other research shows that US firms' net interest payments as a share of cash flow have also fallen since 2022, reaching their lowest level in nearly 70 years.

Implications of Future Rate Cuts

With the Fed expected to begin easing rates next week, there are debates over how effective such cuts will be in stimulating the economy if a recession unfolds. Given the limited economic impact of the rate hikes, some analysts suggest that the Fed may need to lower rates significantly to achieve any meaningful stimulus.

However, others argue that the effects of higher rates might only be delayed, pointing to the erosion of cash levels on some household and corporate balance sheets. Despite these concerns, corporate borrowers are still able to roll over their debt, even if they refinance at higher rates. Last week, 59 new debt sales totaling more than US$81 billion marked the fifth-largest weekly volume ever for investment-grade companies.

Market Uncertainty and Caution for the Fed

This complex scenario has led some investors to believe that the Fed should approach rate cuts with more caution than the market currently anticipates. Yves Bonzon, Chief Investment Officer at Julius Baer, argues that uncertainty around how monetary policy impacts the private sector is "very high." He suggests that if the real economy's sensitivity to interest rates is unusually low, it is unclear how asset prices will respond should the Fed cut rates aggressively.

Bonzon warns that easing in the absence of a recession could stimulate already growing private-sector credit, revive the housing market, and reignite leveraged buyout and private equity markets. In this context, he believes the Fed should aim to avoid an asset price boom-and-bust cycle and that three quarter-percentage-point cuts to start would be sufficient while further assessments are made.

BlackRock credit strategists Amanda Lynam and Dominique Bly suggest that much depends on the Fed's intentions. If the Fed is easing to counteract signs of a looming recession, it could lead to significant rate cuts and increased high-yield credit spreads amid fears of an economic downturn. Conversely, if the Fed is merely "normalizing" rates, its terminal rate could remain higher, around 3.5%, with credit spreads staying stable.

Regardless of the perspective, the consensus is that neither the Fed nor the markets can be sure how this situation will unfold in the coming year, implying that investors should brace for more uncertain and volatile months ahead.