ROI-Fed may generate sugar rush in 2026: Klement

(The views expressed here are those of the author, an investment strategist at Panmure Liberum.)

By Joachim Klement

LONDON, Nov 25 (Reuters) - The Federal Reserve's stance has recently shifted from dovish to hawkish and back again, leaving investors uncertain about the prospect of aggressive U.S. interest rate cuts next year. But the central bank remains under political pressure to ease quickly. So if history is any guide, we may yet see a sugar rush economy in 2026.

The Fed at its October meeting cut its policy rate by 25 basis points to a range of 3.75-4.00%, but Chair Jerome Powell struck a notably hawkish stance that was reinforced by the Fed minutes released last week.

This renewed speculation that the Fed might not cut interest rates as much as previously expected. In money markets, the anticipated fed funds rate through 2026 moved back above 3%, and the probability of another cut in December dropped to 40% as of last Thursday from 90% before Powell's October speech.

Then came a statement on Friday from New York Fed President John Williams that interest rates may decline in the "near term." And market bets for a December rate cut started rising yet again. But investors may still be underestimating the potential easing through next year.

Why? It's not because the U.S. seriously risks going into recession if the Fed doesn't cut rates aggressively, despite what Fed Governor Stephen Miran claims.

Instead, it's because the Fed is under significant political pressure from the White House to ease rapidly. History suggests the Fed may give in eventually.

HISTORY LESSON

Going back to 1933, the personal interactions between U.S. presidents and Fed chairs have tilted monetary policy decisions in favour of faster rate cuts, according to an academic paper by Thomas Drechsel at the University of Maryland.

Helpfully, he estimates the impact these rate cuts had on growth and inflation in the years following the political interference. One can use this data to estimate how much the Fed funds rate could move in response to the current pressure from the White House.

This calculation is subjective, of course. I have assumed that the current pressure is similar to what then-President Richard Nixon exerted on Fed Chair Arthur Burns in late 1971, though one could argue that President Donald Trump's frequent public attacks on Powell are more significant.

Under these assumptions, the Fed would be expected to cut its policy rate by an additional 1.0-1.5 percentage points in the next 12 months on top of the actions that would have been warranted based on macroeconomic developments.

In other words, if the Fed responds to political pressure like we've often seen in the past - for example, by emphasising job creation more than price stability - then the rate could drop well below 3% by the end of next year. And under the next chair, who will be appointed by Trump, the Fed may be even more willing to acquiesce to political pressure.

The good news is that these rate cuts should, theoretically, boost real GDP growth in the next one to two years.

The bad news is that growth should then decline rapidly. Drechsel argues that, in the long run, giving in to political pressure does not boost real economic activity persistently. Aggressive rate cuts engineer an economic sugar rush that typically disappears once the rate cuts stop.

PRICE OF ACCOMMODATION

There's more bad news. While politically-influenced rate cuts have not been shown to increase real economic activity over the long run, they have produced one persistent change - higher inflation. Aggressive rate cuts not motivated purely by economic fundamentals have historically overheated the economy, boosting inflation even two to three years down the line.

Importantly, this increase in inflation is typically larger than what is seen during a normal rate-cutting cycle because doubts about central bank independence usually cause inflation expectations to move higher. This can create a vicious cycle where inflation risks getting out of control unless the Fed hikes rates aggressively.

Clearly, none of this is a given. First, Powell and other Fed policymakers continue to vouch for the independence of the Fed, despite the public attacks.

Next, if the U.S. economy really does slow significantly, cutting rates aggressively would likely be the right medicine and thus should not lead to excessive inflation. And dovish Fed members, like Miran, may be right in their call for more aggressive rate cuts.

But the history lesson is pretty clear. No matter how you slice it, cutting rates aggressively when inflation is running at 3% and the U.S. economy is growing at an annualized rate near 4% would be a risky undertaking.

(The views expressed here are those of Joachim Klement, an investment strategist at Panmure Liberum, the UK's largest independent investment bank).

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(Writing by Joachim Klement ; Editing by Anna Szymanski and Marguerita Choy)