The Federal Reserve sent investors a Holiday gift on Wednesday, cutting its benchmark "federal funds" interest rate by 0.25 percentage points, bringing the federal funds rate to its lowest level in more than three years to a range of 3.75 - 4.0%.
Chart 1: Federal Funds target interest rates from Jan 2000 to Dec 2025.
While the equity market cheered the news, anyone expecting this cut to help bring down mortgage rates was likely disappointed. The 10-year US Treasury note, on which many mortgage rates are based, saw its yield climb at the same time as the Fed was cutting short term rates.
In summary, the bond market didn't see this rate cut as a gift at all, effectively "returning it to the store", unopened.
In his statement on the Fed's action, Chairman Jerome Powell cited weakness in the labor markets as the motivator for lowering rates. Yet inflation is still well above the Fed's stated 2% target level.
The bond markets let the Chairman know that lowering rates at such a time could cause inflation to rise. So, investors demanded higher rates on the 10-year note to reflect the possibility that inflation will eat away a larger portion of the principal value over time.
This is not the intended outcome of interest rate cuts.
What are the long-term effects of this action?
The Fed has a "dual mandate" to maintain maximum employment and stable prices. These two goals are often in conflict, and the Fed has a delicate balancing act to orchestrate.
The Fed influences business activity with interest rate levels, but it also influences market direction and overall interest rates through its statements and its credibility.
Over the short and long term, the Fed has to be seen as being committed to the second part of its mandate -- stable prices. Once that credibility is lost, investors build in an "uncertainty premium" on the rates they demand to earn from that same 10-year note.
In other words, when investors doubt the commitment of policy makers to future value of money, all bets are off. All precision is gone. Investors will demand even more interest to allow for a potentially larger erosion of value.
This has been referred to as "Letting the Genie Out of the Bottle" -- defined as an action that can lead to unpredictable consequences.
The History
In the 1970's, inflation became sticky in the US. By the early-1980's, the Fed needed to re-establish credibility as a steward of purchasing power. Their draconian policies included aggressive interest rate increases -- with the federal funds rate ultimately reaching a target range of 19-20% by March 1980.
Their willingness to induce a severe recession in order to "break the back of inflation" signaled their strong commitment to "sound money". Investors became increasingly convinced of the permanence of the stance, eventually allowing rates to steadily decline over the next several decades.
The example makes clear how economically painful it can be to put the Genie back into the bottle.
Today, by lowering rates during a period of above-policy inflation levels, the Fed risks damaging its credibility as an inflation fighter. Their public statements attempted to convey the "transient" nature of inflation (as being largely driven by tariffs and the government shutdown) and they signaled that future rate decreases would be data-driven.
Rising yields on the 10-year note, however, show these comments failed to convince bond investors.
What is the Future Direction for Inflation and the US Dollar?
Could this rate cut be foreshadowing that Powell's replacement next year will be even more influenced by non-economic factors? Investors will be watching closely for signs of unorthodox policy choices and priorities.
My perspective on this might be more sensitive than many. As one who spent nearly a decade investing in emerging countries, it became crystal clear to me that a truly independent central bank is the key to a stable currency. When that currency declines in value, it is often a sign that price stability is less of a priority for those whose job is to preserve it.
This tug-of-war between two sides of the dual mandate is nothing new, of course. There is still ample opportunity for the Fed to maintain its credibility, and there is no reason to believe that the Central Bank is yet losing its independence.
But investor confidence and policy credibility are two intangible factors that are critical elements in economic policy. They are earned over time and are hard to re-establish once lost.
Closing: The Ferrari
In a 2013 speech, Mark Carney, who was at that time Governor of Canada's central bank (now Canada's prime minister), stated the following about the loss of confidence in financial institutions after the 2008 Global Financial Crisis:
"Trust arrives on foot but leaves in a Ferrari."
That Ferrari in the garage for now. Clear policies from the Fed that honor both sides of its dual mandate will help keep it there.