The Big Question I Want To Ask The Fed This Week…

“What will you do the first time your toddler gets swallowed by a tumbleweed?” 

I actually ask people that question a couple times a year. It comes up in conversation when tourists cross my path here in Wyoming. That question is also my favorite example of unintended consequences. 

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First of all, tumbleweed is big but it’s light. So, kids don’t get hurt when the wind blows tumbleweed into them, or when the wind blows the littlest kids into the tumbleweed. They just untangle themselves and keep playing. 

But tumbleweed is an unintended consequence of living in the country. It’s a weed, so it cannot be stopped. It’s an excellent example of the annoyances that disrupt life in the country. 

I first came up with the question to deal with an unintended consequence of GPS. Ten years ago, when the rodeo brought tourists to town, we only saw them in the country when they were lost. Back then, they were happy to see a person among the cattle and horses so they could get directions back to their hotel. 

With GPS, people wandering the countryside today are doing so deliberately. Some seem to be dreaming of the cowboy lifestyle. Between you and me, they can be just as annoying as the tumbleweed. 

I should probably be more patient with these countryside interlopers and share the good and bad of this lifestyle with them, but my tumbleweed question gets right to the point: Out here, things are different than what you expect. 

I wish I could be in Washington this week to ask that question at the Fed meeting. The Federal Reserve is expected to cut interest rates, and I’d like to be confident that the Fed has considered the unintended consequences of a rate cut. 

The Fed uses interest rates to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” That’s the Fed’s job. Lower rates are intended to increase employment. 

In the past, when the Fed cut rates, unemployment was rising. This can be seen in the chart below, which uses the discount rate. I selected the discount rate for this chart because policy changes are easy to see in the data, which isn’t very volatile. 

discount rate vs unemployment chart

Unfortunately, the discount rate is no longer used so the next chart shows the fed funds rate. It moves in the same direction but is more volatile. 

Fed funds rate vs unemployment rate chart

The Fed is expected to act this week without clear evidence that the unemployment rate is rising. In fact, unemployment remains near historic lows. It seems unlikely the rate cut is needed to promote maximum employment. 

Rate cuts could increase inflationary pressure, so the cut is not intended to promote stable prices. Based on the data, there doesn’t seem to be a need to cut rates. The cut seems to be driven by concerns that the economy could slow. Those concerns are related to slowing growth in the rest of the world and the threat of a trade war. 

By not waiting for an increase in unemployment, the Fed risks creating inflation. 

If lower interest rates work as intended, businesses should invest in their operations. Economic theory says businesses should borrow at lower rates to increase investment in projects that offer returns that are higher than the cost of the loan. 

If companies borrow, they will create jobs when they put the money to work. With low unemployment, businesses will compete for workers by increasing wages. The higher wages will force businesses to raise prices and that could set off an inflationary spiral. 

Clearly, an inflationary spiral is potentially an unintended consequence of the Fed’s actions. But it is the consequence that standard economic theory indicates is most likely. 

Fed officials are hoping this time will be different. That’s a dangerous thing to do. But the danger is in the long run. 

In the short run, the rate cut could boost stock prices. That’s because central banks around the world are cutting rates and investors have turned to stocks to find adequate returns. This means stocks are likely to continue drifting higher over the next few months. 

But as I noted last week, we should expect volatility along with gains. This week, the Fed’s announcement should create some volatility. The chart below shows the volatility could coincide with a down move. 

DIA MACD chart

That’s a chart of the SPDR Dow Jones Industrial Average ETF (NYSE: DIA). I like using charts of ETFs rather than indexes for analysis because ETFs are tradable. The vertical lines mark previous Federal Reserve meetings. The indicator at the bottom is the popular MACD indicator. 

The Moving Average Convergence-Divergence (MACD) indicator highlights shifts in the direction of price momentum. That makes it a useful indicator to time trade entries since long traders are more likely to be successful when the momentum is just beginning to turn up, and sell signals should work best when momentum first turns negative. 

For seven of the past eight meetings, MACD correctly forecast the trend of DIA in the days after the Fed’s announcement. I’m simply looking at whether the MACD is bullish or bearish to forecast the trend. 

Heading into the announcement, MACD is bearish, which points to a selloff. However, as stocks should once again drift higher over the next few month’s, this week’s selloff should be a buying opportunity.

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