No one knows if the Fed’s aggressive 75-basis-point cut in interest rates yesterday will soothe the markets and stabilize the economy. But slicing the price of money so deeply in one fell swoop rearranges risk, creating new opportunities and new pitfalls in the process.
Let’s start with the suspicion that the central bank’s latest easing was motivated by the tumble in stock markets around the world. The case looks fairly compelling. With only a week before the regularly scheduled FOMC meeting, when a rate cut was widely expected, the Fed lowered its key Fed funds rate early and deeply. Was the move solely about shoring up a weakening economy? Partly, although there’s more to the story. Otherwise, why didn’t the Fed cut last week? Was there some new economic news moving to Fed to action? No, but stocks around the world were collapsing and so the central bank decided to minimize the damage yesterday, the first day of U.S. trading since Friday.
No central bank can afford to ignore the signals emanating from financial markets. But there’s a fine line between ignoring and pandering. Only history will decide if the Fed is deploying monetary policy judiciously in pursuit of balancing its dual mandate of maximizing economic growth and minimizing inflation. Meantime, it’s hard to shake the suspicion that the Fed’s reacting to Wall Street rather than Main Street. Correct or not, the central bank can’t afford to let such a perception take root without creating a bull market in expectations that the Fed ultimately can’t satisfy.
Ill-conceived or not, the Fed cut is reality, and when you slash rates that much that fast the action reorders risk. One example is REITs, which popped yesterday amid falling stock prices. The Vanguard REIT Index ETF (VNQ) on Tuesday jumped 2.3%. Not bad on a day when U.S. stocks fell more than 1%. Why were REITs a safe harbor yesterday? Some of it has to do with the fact that real estate securities have been declining for some time. Perhaps more important is that the relatively rich yields in REITs suddenly look that much more alluring in the wake of a massive rate cut.