Insurance cuts: What, when, why
Summary: Some useful background on the concept of insurance cut/hike that has recently emerged in FOMC minutes and was pointed out by Chairman Powell.
The Federal Reserve of Dallas has published a very well-written and timely piece on insurance cuts based on the study of the FOMC meeting minutes and the full transcripts in 1994 through 2013 (you can access it here). It gives some useful background on the concept that has recently emerged in June FOMC minutes and was pointed out by Chairman Powell at his press conference on July 31st.
It also includes very nice charts to illustrate the discussion as you can see below.
An insurance rate hike/cut refers to a preemptive action from the central bank when the Fed sees more downside risks (for instance, labor market overheating, slower growth, or risks to growth related to trade war friction like it was the case in past July).
This is not a new concept. Media focused on a series of three consecutive rate cuts in 1998, to face the failure of the hedge fund LTCM and the Asian economic crisis, as a prime example of monetary insurance. In fact, over the past three decades, the Fed has implemented many times insurance moves:
Feb 1995 – insurance rate hike due to fear the economy was overheating, thus leading to excessive inflation
Fall 1998 – insurance rate cut (as mentioned above)
Nov 2002 – insurance cut
June 2003 – insurance cut
Interestingly, on many occasions, insurance cuts/hikes were offset in less than one year. The insurance hike of 1995 was removed within a year, which was also the case for the series of cuts of 1998.
It does not mean that the Fed misjudged the evolution of the economic activity, but it mostly shows that monetary insurance is used for the “fine-tuning” of the economy and can be reversed quite fast if needed.
Why does this matter?
It matters more than ever as many recent researches pointed out the importance of acting decisively (preemptively?) in the context of post QE era and ZNLB (Zero Nominal Lower Bound). This is exactly what officially motivated to Fed to cut rates in past July and probability to cut rates in the upcoming September FOMC meeting again.
Contrary to previous monetary insurance, the recent move was justified by recession of global trade and trade war conflict. This is quite unique that the Fed focuses so much on the global context. It has always taken into consideration this factor, but this is the first time that it plays a dominant role in monetary policy decision.
The evolution of the balance of risks is key regarding the implementation of insurance cut/hike and, contrary to what most commentators highlighted, this is not a new concept in the Fed toolkit.
Where I disagree with Chairman Powell is on where we are in the current business cycle. Initially, he referred to “mid cycle adjustment” when announcing the last insurance cut. However, evidence is compelling we are not mid cycle, not even late cycle but rather at the end of the business cycle. When the Fed sees insurance cuts, I see new monetary easing cycle. In my view, we can at least expect two more rate cuts by the end of the year, in September and in December, and more cuts in 2020 due to the global economic slowdown. At the end of the day, the Fed will have interest rates close to zero.
We are not facing insurance cuts to give a temporary push to the economy. We are entering a new global easing cycle to cope with lower growth than expected and mounting risks. It clearly does not have the same market implications.