Is it "politicized" interest rate cuts or data-driven interest rate cuts?

Written by: Li Xiaoyin

Source: Wall Street View

The Federal Reserve's monetary policy meeting will be held this month, and the current market focus is on whether the independence of the Federal Reserve will be compromised, and whether the upcoming interest rate cuts will have a "politicized" nature.

Recently, Peter Tchir, the head of macro strategy at Academy Securities, stated that these concerns have fostered a widespread expectation: even if the Federal Reserve initiates interest rate cuts, it will only lower short-term rates, while long-term yields will face upward pressure due to inflation concerns. Currently, this view has become mainstream in the market and is guiding many investors' positioning.

However, Tchir believes that investors may have failed to "think outside the box" sufficiently, thus underestimating the government's plan to lower interest rates. In addition to traditional monetary policy, the U.S. government may adopt a series of unconventional measures, including adjusting the Federal Reserve's balance sheet, changing the way inflation data is reported, and even revaluing gold reserves to achieve its goal of lowering long-term rates.

Tchir added that these potential policy options go beyond simple interest rate cuts and may involve coordinated operations among the Federal Reserve, the Treasury Department, and even accounting standards.

"Politicized" interest rate cuts or data-driven interest rate cuts?

Concerns about "politicized" interest rate cuts may overlook the economic rationale behind the cuts themselves.

The article states that if there are sufficient data-driven reasons to support significant interest rate cuts, then the market's panic over long-term rates may not occur.

Tchir pointed out that signs of economic weakness had already appeared before officials began to disagree on the issue of interest rate cuts. For example, at the July Federal Reserve meeting, two officials had already expressed dissent regarding the decision not to cut rates, and the subsequent June employment data was significantly revised downward; Powell's speech at Jackson Hole also exhibited a dovish stance.

These signs indicate that the reasons supporting interest rate cuts within the Federal Reserve may be more substantial than what the meeting minutes revealed.

Tchir believes that if subsequent employment data fails to show strong improvement, a 50 basis point rate cut in September is entirely within the "reasonable" range and should not be simply viewed as politically driven. If the rate cut is seen as justified by the market, then the "alarm" that investors expect—namely, the sell-off of long-term bonds—will be less likely to materialize.

The effectiveness of traditional interest rate tools is diminishing

Tchir believes that another reason the U.S. government is considering unconventional options is that the effectiveness of traditional monetary policy tools is waning.

The article explains that merely adjusting the front-end federal funds rate to influence the economy has a "long and variable" lag in its transmission path, making its effects difficult to assess. Within months of policy implementation, any factors such as trade wars or geopolitical conflicts could alter the economic trajectory.

Moreover, since the era of zero interest rate policies, many businesses, individuals, and municipal bond issuers have locked in long-term low rates, significantly reducing their sensitivity to changes in front-end rates. This means that the effectiveness of transmitting monetary policy through short-term rates is no longer what it used to be.

What might be in the "toolbox" of unconventional policies?

If the effects of traditional tools are not significant, the government may open its unconventional policy "toolbox" to directly intervene in long-term rates.

Aggressive rate cuts combined with forward guidance

One possible strategy is to "go all in." For example, a one-time significant cut of 100 basis points, while committing to keep rates unchanged for the next few quarters unless there is a substantial change in data.

This move aims to quickly dispel market speculation about the future path of interest rate cuts. A one-time cut of 100 basis points would require a significant steepening of the yield curve to keep the 10-year U.S. Treasury yield above 4%, which may be a challenging task for "bond market vigilantes."

Attacking inflation from a data perspective

Another strategy is to directly challenge the validity of inflation data. Currently, the housing cost component, which has a significant weight in the U.S. CPI, is artificially inflating inflation data due to its lagging algorithm for "owner's equivalent rent" (OER).

Tchir pointed out that a new index compiled by the Cleveland Fed shows that real rent inflation has returned to normal levels, far below the housing inflation in the CPI. By emphasizing these data discrepancies, the U.S. government can effectively weaken market fears of inflation, clearing the way for interest rate cuts.

Reinitiating "Operation Twist"

The core method may be to restart "Operation Twist" (OT), by simultaneously selling short-term U.S. Treasuries and buying long-term Treasuries to lower long-term rates.

Currently, the Federal Reserve's balance sheet is heavily weighted towards short-term debt, holding about $2 trillion in bonds with maturities of 7 years or less, while only $1 trillion in bonds with maturities of 15 years or more. Analysts envision that the Federal Reserve could sell about $1.2 trillion in bonds with maturities of 3 years or less and use the proceeds to purchase long-term bonds with maturities of 20 years or more.

Tchir noted that this move would nearly double the Federal Reserve's holdings in the ultra-long bond market, and the purchasing power would be sufficient to influence or even control about 50% of the free float in the ultra-long bond market, thereby directly lowering long-term yields.

Other potential options

Other more disruptive options may also be considered.

For instance, yield curve control (YCC), although unprecedented in the U.S., has been practiced in Japan, and for a government accustomed to "setting prices" through tariffs, setting caps on yields is not unimaginable.

Additionally, revaluing U.S. gold reserves is also an option. It is estimated that if the U.S. official gold reserves were revalued at market prices, it could generate about $500 billion in accounting gains. Although complex, this move could effectively divert market attention and potentially provide funding for other investment plans.

Tchir added that this could lead to a weaker dollar, but for a government aiming to improve the trade deficit, this might be "a feature, not a flaw."

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