When will the Federal Reserve cut interest rates?

Last year, I wrote an article arguing that we should not easily bet on the Federal Reserve lowering interest rates soon, but rather be on guard against the possibility of the Fed raising rates.

Since then, I have not written any articles speculating on Federal Reserve policy, as the market has been filled with optimistic comments about rate cuts, which are clearly contrary to my viewpoint.

However, the change in market sentiment since then has been quite interesting: from an initial optimism about imminent rate cuts (some said December of last year, others said March of this year…) to now hardly mentioning rate cuts in the first half of the year.

The reason for such irrational market sentiment, which I shared in a Twitter exchange at the beginning of the month, is that many articles and opinions discussing rate cuts are irrational and emotional, lacking even basic logic.

I have previously stated that the Federal Reserve's policy is not a "conspiracy" but a "public strategy," meaning that unless a black swan event occurs, it will act transparently according to its publicly established rules. Even if it wants to play "tricks," it will do so openly and not randomly.

What does it mean to be open and transparent?

It means that it will publicly share its views and thoughts, and whether readers can discern the "subtext" from it depends on their own abilities.

However, 99.99% of the articles in the market cannot read this "subtext," so they can only guess and gamble.

Today, I would like to share a high-quality article interpreting the Federal Reserve's (future) intentions (see the article link at the end).

This article interprets the speech by Federal Reserve Governor Christopher J. Waller titled "Some Thoughts on r*: Why Did It Fall and Will It Rise?" delivered on May 24 in Iceland. The full text is publicly available on the Federal Reserve's official website, accessible to anyone.

Currently, the U.S. market generally believes that as long as Trump is not negatively affected by legal issues, the probability of him winning the election at the end of the year is quite high. If Trump is elected, the market believes that Waller is likely to succeed Powell as the next chair of the Federal Reserve.

This speech reflects Waller's thoughts on the current interest rate policy in the U.S., which can help us glimpse the possible direction of future Federal Reserve policies.

Before introducing the interpretation of this article, let me share two preliminary knowledge points:

The relationship between government bond yields, prices, and coupon rates.

The differences in governance philosophies between the Democratic and Republican parties in the U.S.

I have previously written an article specifically introducing the relationship between government bond yields, prices, and coupon rates.

In summary, the coupon rate of a government bond is fixed. However, once the bond is issued and listed, its actual yield becomes less related to the coupon rate and is closely tied to the trading price of the bond. The higher the trading price, the lower the actual yield; the lower the trading price, the higher the actual yield.

When the government issues new bonds, the coupon rate of the new bonds is closely related to the actual yield of existing trading bonds. If the actual yield of existing bonds is very high, setting a low coupon rate for the newly issued bonds is meaningless, as it is likely that no one will buy them or they will be forced to issue at a discount.

Therefore, if the expectation is for the coupon rate of newly issued bonds to be low and to be issued smoothly, the actual yield of existing bonds cannot be high. So how can we control the actual yield of existing bonds to keep it from being too high? One important market strategy is to reduce the supply of bonds in the market, driving up their trading prices and lowering their actual yields.

Next, let's look at the differences in governance philosophies between the Democratic and Republican parties:

The Democratic Party has always advocated for a large government, believing that a strong government has enough power to ensure fairness, help the weak, and maintain stable and healthy social development.

In contrast, the Republican Party's philosophy is that the government should only focus on maintaining order, regulation, legislation, and law enforcement, while leaving other matters to the market. This allows the market to fully unleash its vitality and creativity. The direct consequence of an overly powerful government is that public institutions become bloated, the bureaucratic system becomes inefficient, ultimately leading to the breeding of corruption and abuse of power, interfering with the free market and preventing it from functioning properly.

These philosophies of the two parties translate into fiscal policy as follows:

A Democratic government needs to establish more agencies, hire more civil servants, manage more affairs, and intervene more in market operations, all of which require more money. The most direct way to obtain money is to issue more government bonds—i.e., increase the supply of government bonds. The direct consequence of this is to force the trading prices of bonds to fall, resulting in higher actual yields.

In contrast, a Republican government hopes to cut unnecessary government agencies, reduce unnecessary civil servants, and minimize unnecessary government intervention, which naturally reduces government spending, meaning that it does not need to issue too many bonds—i.e., reduce the supply of government bonds, leading to higher trading prices and lower actual yields.

Of course, the scenarios listed above are classic situations in a very ideal state. The current Democratic and Republican parties in the U.S. are no longer 100% classic. However, the two parties still maintain significant differences in some basic principles and policy philosophies, and the policies they formulate will also be noticeably different.

Now, let's look at the analysis of Waller's speech in this article.

In the Federal Reserve's public statements in recent years, there has often been mention of controlling the "neutral interest rate" at a certain level.

What is the "neutral interest rate"?

Waller uses two indicators to measure it: the actual yield of 10-year government bonds and U.S. inflation-protected securities.

The conclusions drawn from the analysis of Waller's speech in this article are as follows:

"What Waller really wants to express is that the neutral interest rate in the U.S. is continuously rising, primarily due to the overwhelming supply of government bonds. This, in turn, explains why the Federal Reserve has been hesitant to lower interest rates. In simple terms, since the neutral interest rate, as a reasonable standard, is rising, lowering the policy interest rate becomes unreasonable. To reasonably lower the policy interest rate, the neutral interest rate, which serves as a reasonable standard, must first be lowered. And the current neutral interest rate is being pushed up by the continuous overissuance of government bonds."

"Or to put it more bluntly, what Waller wants to express is that as long as the left-wing Democratic Party is in power, government bonds will inevitably be overissued, the neutral interest rate will inevitably rise, and the Federal Reserve will be hesitant to lower interest rates. Only when the right-wing Republican Party is in power can the issuance of government bonds be reduced, the neutral interest rate can fall, and the Federal Reserve can decisively and continuously lower interest rates."

This analysis reads the "subtext" of Waller's speech.

Does this mean that the Federal Reserve will not lower interest rates before this year's election?

My understanding of this point differs slightly from the analysis in this article.

I believe it does not mean that; it merely expresses the potential future Federal Reserve chair's true views on interest rates and the measures he tends to take:

To lower interest rates decisively, in addition to other policy measures, reducing the supply of government bonds is likely a very worthwhile operation to consider.

So, we can now seriously observe whether the U.S. government will move in this direction.