It has been an eventful week, with, by any metrics, an election for the ages. What really stuck out for me is how wrong pollsters got it, and how right the prediction markets were. Yes, going into the later days of the race, there was talk (mostly from pollsters) that the prediction markets were possibly being manipulated. In retrospect that theory did not hold up. It should come as little surprise that when investors have “skin in the game”, they tend to make better forecasts in aggregate, since the payoff for being right is profit, not just a checkmark on the reputational tally table. They have skin in the game, in other words. As an investor, it is not just enough to be right, it is also essential to get the consequences right in real time.
As with every previous election, at my firm we ran a “game” the night before the election, with the prize being a free dinner for anyone who got both the winner and the direction of the market right. The wisdom of our little “crowd”, on average, got both the winner and the consequences (a sharp rally in stocks) right. And one person in particular nailed it and won the free dinner.
The election’s outcome and the performance of the market makes the job of Jay Powell and the FOMC meeting today much harder. From my perspective, the last 50 basis point cut in the face of a strong economy and booming market was probably a “political” move, and not necessary given economic conditions. On balance, it had the potential of tilting the election odds toward the incumbent party, since a booming stock market makes voters more likely to be in a positive frame of mind when they go to the polls, or are mailing in their ballots. The stock market did rally after the prior big rate cut, even in the face of a sharp selloff in the bond market that basically nixed the Fed’s actions. Yields have risen close to 0.75% since the 0.50% cut, showing what the market thinks about the actions. That was a vote by the bond vigilantes that the cut was neither required nor appreciated in light of economic conditions. But the Fed works on managing and delivering on the expectations it creates, and the expectations were managed toward the large cut, and so had to be delivered, market and economic conditions notwithstanding.
Which brings me to the decision today. There is again no need to cut today, since the stock market has made record highs, there is euphoria in the markets, and the economy is doing just fine. But disappointing the market by not cutting would be against the expectations that the Fed has built into the pricing of assets. On the other hand, the results of the election are out already – there is nothing political to be gained right now. The last move did not help the incumbent party. A political Fed will, if this theory is correct, keep its powder dry, so to speak, as a gift for the incoming President, who is likely to be appeased by a large cut right after taking office. In other words, game theory, as applied to the Fed, suggests that the Fed will hold off its 0.25% expected cut today, and possibly again as expected for the December meeting, and deliver a super-sized cut after the inauguration. Delaying the cut will not only allow the Fed to use rational economic logic, but also buy itself some bonus points from a leader who wants the Fed to be aggressive in lowering interest rates at his direction. It’s a win-win, and thus the path of least resistance. Quite logical, actually. As for disappointing the markets — not that it factors into the Fed’s decisions — does it actually matter now that stocks are at record highs? And not cutting today might actually calm the bond market down, which in the long run might be good for the deficit, amongst other things.
I am quite aware that skeptics of the logic above will react to my prognostications as being too simplistic and skeptical. Certainly there will be pushback on the idea that the Fed, and Jay Powell, are making decisions that are politically motivated. Yes, that is not the way it “should” be, but that’s the way it is, unfortunately. With a string of bad economic calls and bets over the last five years, the Fed’s independence is at risk. The results of the election have made this an existential issue, so I suspect that the Fed will play the game that allows it the best chance of surviving under the new President. And it also makes economic sense.