What the Federal Reserve’s interest rate cut actually means

A funny thing happened on the way to the Federal Reserve’s latest interest rate cut: borrowing costs have actually risen. And by a lot.

Worse, the credit markets have experienced a liquidity squeeze — not enough money to go around — the likes of which hasn’t happened since the last financial crisis.

That doesn’t mean there is another crisis on the way. But it also doesn’t mean that there isn’t.

The Fed cut interest rates by one quarter of a percentage point yesterday. They call that a 25 basis point cut on Wall Street, and now the range of the so-called Fed Funds rate is between 1.75 percent and 2 percent.

Fed funds is the rate that banks borrow from each other short-term, usually overnight. It’s also the rate that the Fed lends money to banks in a pinch.

As I’ve said often, the Fed only has influence over short term interest rates. The Fed funds rate has little to do with money borrowed and lent over a 2-year, 10-year or 30-year period.

This latest cut in interest rates, which is the second this year and only the second in a decade, was widely expected. And it comes at a time when President Trump has intense pressure on the Fed to reduce rates and at a time when the US economy is doing well enough not to need cheaper money.

Just yesterday the Federal Reserve Bank of Atlanta estimated that the nation’s economy, as measured by the Gross Domestic Product, was expanding by a 1.9 percent annual rate in the third quarter that ends in a week and half.

Nearly 2 percent growth isn’t fantastic but it is also no reason to panic. And with the unemployment rate low and job gains still impressive, there’s little worry that the US is headed for a recession.

Powell, in his press conference after the rate cut, even said he expected job growth to remain strong. The Fed certainly doesn’t seem to think a recession is imminent.

Trump wants rate cuts for political reasons, so he’s kept his boot on Fed chairman Jerome Powell’s neck for a long time. Most recently he called the Fed a bunch of “boneheads.”

That, plus comments recently by Bill Dudley, the former head of the New York Federal Reserve bank, is making the market nervous about whether Powell is really paying attention to the economy with his rate cuts or to the people yelling in his ear.

The New York Fed is closely aligned with Wall Street firms because that’s where the Fed intervenes in markets. So when Dudley said recently the Fed should work to keep Trump from being reelected (something he later said was misinterpreted) it caused serious concerns about the political neutrality of the US Central Bank.

How nervous is the bond market? At a time when most of the discussion is about lowering interest rates, the rate on the US 10-year note rose from 1.47 percent on Sept. 3 to 1.81 percent earlier this week.

That’s a big jump, although all rates fell a bit yesterday on the Fed’s action.

The 30-year US government bond’s rate rose from 1.95 percent on Sept. 3 to 2.27 percent on the 17th. And that bond’s yield peaked at 2.37 percent just days before that.

The value of fixed rate securities like 10-year notes and 30-year bonds move in the opposite direction as interest rates. So, as rates have been rising the value of bonds that have already been issued declined.

In fact, the jump in yields in September wiped out any profit someone would have collected from the yield on a 10-year bond for the entire year.

While these longer-term rates were rising, the short term rates that the Fed has influence over haven’t moved very much. The one-month government-issued bill, for instance, was yielding 2.06 percent on Sept. 1 and only jumped to 2.10 percent. The two-month and three-month bills had similar small gains.

But the six-month bill rose from just 1.88 percent on Sept. 1 to 1.93 percent on Sept. 17. This shows that the Fed’s influence isn’t extending beyond a couple of months in investors’ minds.

Another thing has also changed. The so-called “inverted yield curve” is no more. Longer term fixed rate securities are supposed to yield more than short term ones because investors take a greater risk when handing over their money for a longer period of time.

When short term rates are higher than those on long-term securities, the curve inverts and that – according to Wall Street lore – is a sign that a recession is coming.

Rates were inverted early in September and that led to howling by “experts” and Trump haters that a recession was on the way. But that inversion ended in mid-September and talk of an imminent recession has quieted down.

The Fed’s comments on Thursday should also calm recession fears. Two voting governors of the Fed voted against even the modest quarter-point cut in rates. Another one — who looks like he’s sucking up to replace Powell if Trump fires the Fed chief — wanted a bigger, half-point rate cut that the president has demanded.

With all this and lots more stuff going on in the world — Middle East tension, trade fights, horrible economic conditions in other countries, a possible bank liquidity crises and never-ending political chaos in Washington — the outlook for future rate cuts can best be described as uncertain.

But yesterday’s message from the Fed seemed clear and Wall Street heard it. The likelihood of more rate cuts is more iffy that it was just a short time ago.