The Week Ahead – Avoiding an Economic Hangover

Welcome to “The Week Ahead” where we take a moment to provide our thoughts on what we can expect in markets and the economy during the upcoming week.

Over the weekend I attended a very upscale bat mitzvah hosted by some family friends. They went all out with the venue, incredible food and a top-shelf open bar. Since I’m not much of a drinker, I wouldn’t normally be tempted, but as they had my absolute favorite single malt Scotch, Macallan, I figured it would be rude to refuse such generosity. The first glass went down so easily, I didn’t turn down the offer for a second. Again, since I so rarely partake, two drinks of whiskey was plenty. When the bartender came by to offer me another, I thought about the economic law of diminishing returns. While the first glass was delicious and added to the joie de vivre of the evening, and the second glass was also quite enjoyable, a third while tempting, would have produced negative utility – an economic euphemism for a hangover.

Faced with slowing economic growth, the Federal Reserve (Fed) has clearly set expectations to start cutting interest rates at the end of the month. Many economists now agree that the rate hike last December was probably an overshoot, so reversing that action in July seems justifiable. While one or perhaps even two cuts would help engineer a soft landing, a third or even a fourth cut would bring the Fed Funds rate well below the rate of inflation. This powerful monetary stimulus could cause the economy to overheat resulting in dangerous asset bubbles and the potential for a wage/price spiral. These concerns are complicated by the fact that the two recently announced Fed nominees will likely to be supportive of significant rate cuts.

The inflation data delivered this week is incredibly important to the Fed’s decision calculus. If the inflation impulse continues to weaken, the temptation to lower interest rates will be very strong. However, if inflation data come in stronger than expected, that could mean fewer rate cuts than the market is expecting, and that would most likely mean an undoing of some of the strong price action in risk assets. Given the slowing of global growth, lowering interest rates makes sense, however; too many cuts, no matter how tempting, could result in a nasty hangover.

Data deck for July 8–July 12: