The Federal Reserve may have made a huge mistake

In what looks like a fit of panic, America's central bank cut interest rates yesterday. And the markets didn't like it one bit. Dominic Frisby explains why.

Call me naive (or worse) but I can’t help thinking the Federal Reserve – America’s central bank – got it wrong yesterday.

With its emergency interest rate cut of half a percentage point, the S&P 500 – already rallying without the need for stimulus – initially rose by more than 70 points to 3,130, before embarking on a sell off that saw it fall at one stage by more than 150 points.

The low for the day was 2,976. But markets have rallied overnight and this morning (judging by the futures markets) we sit around 3,040. Talk about wild swings...

This looks too much like a central bank panic

My initial reaction when I heard the news of the Federal Reserve’s big rate cut was: “What are they doing? This is the wrong thing to do.”

There are many who know a great deal more about economic policy than I do. But I set a lot of store by my initial reaction, because there will be plenty of others to whom the same thoughts occur.

In my trading account (short-term play money) I had actually bought the US indices the day before. But as soon as I saw the news and the market reaction, I sold. It was a classic instinctive trade, based on news and emotion, and that is a terrible way to trade. Rules-based systems are so much better.

But I just didn’t like what I saw – and nor did the rest of the market by the looks of things – and so the rules went out of the window. Judging by the level of volatility – caused by sheer uncertainty over the potential impact of coronavirus – I don’t think I’m alone in ignoring my normal rules.

And I think you can include the Fed in that. The Fed is made up of human beings just like the rest of us. To me it looks as though they panicked. They were already under pressure from Donald Trump to cut rates, they looked at the volatility, and then bent or broke their own rules.

In theory, lower rates may incentivise risk-taking. But ultimately, market participants have to be confident enough to take that risk. There are so many economic unknowns at the moment, that many are not.

So the Fed has now left itself with even less room to cut if it needs to. It has also revealed two things about itself, which perhaps it should not have: how easily it panics, and just how willing it is to prop up markets when things look dicey.

Perhaps the Fed has blown its cover

You often hear football pundits and the like talk about turning points. That was the point at which club X changed its formation, or player Y started to get forward more, or manager Z was appointed – and things changed after that. Pundits love turning points because they add to the narrative, and human beings respond to narratives.

I’m rather more skeptical about the idea of turning points in the gradual, ceaseless flow of real life. I wonder if they are things we impose on that flow after the event to give it definition.

Nevertheless, part of me wonders if yesterday’s action by the Fed might prove to be a turning point. For decades, hard-money advocates (and I am one) have been waiting for the turning point – the point at which the greater public start to lose confidence in the financial system, in fiat money and central banking. We thought it was happening in 2008. We thought quantitative easing would do it, or ten years of interest rate suppression. None did.

But, yesterday, a lone voice in a distant corner of my soul – lurking somewhere near where the gold is stored – cried out that yesterday’s move was a step too far. It will prove a turning point. You know the voice at the back of your head? The one you should listen to but never do? It was that guy. At least I think it was.

The Fed’s move was designed to encourage consumer and business confidence. Perhaps it does the exact opposite.

Will any of your American friends be booking a holiday because the Fed has cut rates? Are people going to restaurants more because the Fed has cut rates? Will schools or offices or conferences or large sporting events threatened with closure open because the Fed has cut rates?

One of my bitcoin buddies who lives in New Zealand was planning to spend the summer this year in Italy. He’d put down the deposit on a place in Tuscany. He’s just put off making his next payment, however, because of coronavirus.

The travel company assures him: “In Italy the situation is well under control by the authorities and most parts of Italy are totally safe, yet we hear the rumours going around and unfortunately they often are not reflecting reality. We are already seeing great results with the number of new virus registrations going down for each day, and the number of completely cured people going up. We also remain confident that the whole crisis will dissolve within a few weeks.”

The travel company may be right, but my buddy is not convinced. Yesterday’s rate cut won’t make any difference to his mindset, and nor will any cuts by the European Central Bank or the Bank of England, which are no doubt on the way.

From the point of view of the preservation of the financial system, being prepared to act and provide liquidity is probably a positive. But you cannot cure a disease or a virus with interest-rate cuts. Rate cuts do not stop the spread of respiratory droplets between people via coughs or sneezes, nor do they affect structural biology. And they won’t solve climate change.

Central bankers are not gods. Perhaps we’re about to wake up to that.

Daylight Robbery – How Tax Shaped The Past And Will Change The Future is available at Amazon and all good bookstores with the audiobook, read by Dominic, on Audible and elsewhere. If you want a signed copy, you can order one here

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