Is The Fed Playing With Fire? 'We See Greater Risk Of An Overheating Economy' As They Cut Rates, Veteran Investor Warns

Three things in life seem certain as of Wednesday, Sept. 18: death, taxes, and the Federal Reserve’s announcing a cut to the fed funds rate at its imminent Federal Open Market Committee (FOMC) meeting.

What remains uncertain is the size of the cut and its potential effects on the U.S. economy ? particularly its impact on inflation, which still hovers above the Fed’s 2% target.

Investor sentiment, as tracked by the CME FedWatch tool, currently assigns a 63% probability to a 50-basis-point rate cut just hours before the FOMC’s decision. The remaining 37% anticipate a more conservative 25-basis-point reduction.

Wall Street analysts, however, are taking a more cautious stance. The consensus strongly favors a smaller rate cut, citing the potential risks of a more aggressive easing policy and noting political considerations, as September is the final meeting before the upcoming Presidential elections.

Traditionally, the Fed kicks off a rate-cutting cycle with a half-point reduction. Still, many argue that this time is different, as the economy doesn’t appear to be on the brink of recession.

Nonetheless, the future path seems relatively clear to most observers: the Fed is widely expected to continue trimming rates in the coming meetings and into 2025.

Is The Fed Playing With Fire?

In a recent note to investors, veteran investor Ed Yardeni warns that the Fed might be “playing with an economy on fire.”

Consider the most recent economic data: The Atlanta Fed’s GDPNow tracking model recently raised its estimate for third-quarter GDP growth to 3% (seasonally adjusted annual rate), up from 2.5%. This would signal an acceleration of the U.S. economy’s growth, following the 2.8% surge recorded in the second quarter.

“We see more risk of an overheating economy as the Fed lowers rates than an anemic one requiring monetary support,” Yardeni states.

Personal consumption expenditures are projected to rise by 3.7% this quarter, a figure Yardeni deems “hardly recessionary.”

He also praised the latest retail sales report for August, which exceeded expectations, remarking, “As long as U.S. consumers are earning, they are spending.”

Falling gas prices, Yardeni explains, act as a de facto stimulus for consumers ? what they save at the pump, they are likely to spend elsewhere.

Economic Boom, Stock Market Meltup Ahead?

Further supporting Yardeni’s view is the New York Fed’s recent quarterly household spending survey, released Monday. The survey revealed that nominal household spending increased from 4.6% year-over-year in April to 5.0% in August, with spending growth spread across various education levels and income groups.

“We believe this data series faultily understates income growth,” Yardeni notes.

Overall, Yardeni takes a positive stance on the economy. “The labor market is growing, real wage growth is outpacing inflation thanks to productivity gains, and incomes and net wealth are sources of spending rather than credit,” he commented.

Lowering interest rates “too much, too quickly could trigger an economic boom,” resulting in rapid real GDP growth but escalating inflation risks, according to Yardeni.

With the central bank seemingly on the verge of a significant easing cycle, Yardeni warns, “We see greater risk of an overheating economy than a recession.”

“It could also trigger a 1990s style meltup in the stock market,” he adds.

On Tuesday, a day prior to the Fed’s rate decision, the S&P 500 index, as tracked by the SPDR S&P 500 ETF Trust (SPY) , briefly hit record highs.

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