Mike O’Sullivan is Moonfare’s Chief Economist and Senior Advisor. You can meet Mike at many of our community events and investor calls or follow his monthly commentary published on Moonfare's blog.

This week the Federal Reserve will very likely cut interest rates, for the first time since the COVID related rate cutting cycle. 

The Fed cut will come on the back of a series of rate cuts from ‘elder’ central banks — the Bank of England, Riksbank and the Swiss National Bank, as well as the European Central Bank which last week cut interest rates by quarter point to 3.5%.¹

The anticipated move by the Federal Reserve is instructive in several respects. Market based interest rates are lower than Fed rates and many investors expect (or rather crave) the Fed to make a 50 basis point cut, as opposed to a ‘standard’ one of 25 basis points. This is yet another sign of monetary addiction — the result of the conditioning of investors to financial liquidity. In mid-August, following a dip in the stock market, I wrote that the idea of the ‘Fed put’ — the notion that the Fed would react to a fall in asset prices by cutting rates — is very much alive in markets.‍

Crisis of expectations‍

The market dip led several seasoned and apparently credible investors to call for an emergency cut in rates. However, the Fed has only ever taken such dramatic action in the thick of deep crises (LTCM/Russian economic collapse, the dot.com collapse, 9/11, the global financial crisis and the COVID crisis). 

Similarly, it has not begun a rate cutting cycle with a 50 basis point cut, outside of financial crises. There is no financial crisis today (though plenty of mounting financial risks such as very high debt levels), but a crisis of expectations.

That crisis of expectations is at play as investors position for the Fed meeting this week. In my experience, the Fed is, in normal economic conditions, a cautious and slow moving beast, and it would be untypical for them to begin a rate cutting phase with an outsized rate cut. To do so would suggest that they are in a hurry to correct a mistake of their own making.

To that extent, investor behaviour that demands a 50-basis point cut, recalls the quip from Paul Samuelson, the first winner of the Nobel Prize in Economics, that the market has predicted nine out of the last five recessions.

‍Sahm Rule

‍Set against this apparent concern by investors (do they fear a recession or desire lower rates?) is a debate around a relatively new economic rule of thumb called the Sahm Rule, named after research by economist Claudia Sahm at the Federal Reserve.

Her rule states that when the medium term unemployment rate rises an impending recession is signalled (the three month average of unemployment needs to rise by 50 basis points).² It is a surprisingly simple rule that appears to have prefigured eleven US downturns going back to 1953. Sahm’s aim in establishing a reliable rule was that stimulus checks can be sent out at the outset of recessions as opposed to waiting for GDP data to indicate a recession.

I am tempted to trump the Sahm Rule with two observations.

‍Goodhart’s Law

‍The first is Goodhart’s Law, named after Bank of England and LSE economist Charles Goodhart which states that ‘when a measure becomes a target, it ceases to be a good measure’, or more colloquially that fame kills a good model.

More seriously, most of the last ten business cycles were conventional ones, whereas this business cycle bears the scars of reversing demographics, the lingering effects of COVID fiscal policy and labour market distortions (work from home) not to mention the contortions of strategic industrial policy (i.e. the CHIP’s Act, Inflation Reduction Act) and the political ramifications of high inflation and immigration. It is anything but a typical business cycle, and very hard to read.

Somewhat unusually at this stage in the cycle government finances are weak (from France to the US)³ whilst the large corporates of the Western world are in a generally healthy financial state. Of the major economies, China poses the greatest risk to the downside in the near-term.⁴

With different components of the US economy moving in different directions, my expectation is for a slowdown rather than a deeper recession — this may eventually come at the end of 2025 if inflation rises again. 

Equally, I expect the Fed to make a series of rate cuts rather than a deep cutting cycle. If that view is correct, the interest rates market will be very volatile, as investors periodically over react to data points and price in ‘booms’ and ‘busts’.

Expect a market tantrum this week with investors complaining that the Fed is behind the curve. Samuelson would tell us that the curve has got it wrong.

Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. Private equity is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.