The Federal Reserve started a two-day policy meeting today, and the market expects a rate hike. I think they will hike, but they should not.
Wrong tool for the job
Changing rates works on the demand side of the economy. What we have now are supply shocks. Hiking rates will not restart diesel refinery capacity in Russia, and it will not move oil barrels through the Strait of Hormuz. The old line "don't just stand there, do something" should be flipped for the Fed: don't just do something, stand there.
If the Fed hikes, it is likely acting on symbolism over substance. The move would assert its credibility, show it is independent, and give the illusion that it sees a problem and is acting on it. That matters more given White House calls not to touch rates. If the Fed holds, it can look like it is bowing to political pressure, so the optics push it toward hiking.
Inflation squeezing margins
Oil keeps climbing. Brent sits above $106 a barrel, WTI above $102. Inflation is testing companies' shock absorbers, and companies cannot absorb the gap in margins forever.
This is feeding market angst. A big part of why market multiples expanded - the price-to-earnings ratio - came from wider business margins. For every unit sold, whether a good or a service, more money reached shareholders on the bottom line. Fat margins plus fast growth drove the story.
Two things now threaten that. First, growth: over the weekend came word that developers may throttle back building frontier AI models, which puts the expected growth rate in doubt. Second, cost pressure. A few years ago a business could pass a $1 cost increase to consumers and even push it to $1.02. Now the Fed's own Beige Book says businesses feel they cannot pass on cost increases, which shows up as margin pressure.
So there is doubt around both the growth parts of the market and margins. That is a recipe for more of a pullback, a reset that asks what the foundation is, which businesses are high quality, and whether they can protect margins and still grow.
Will AI leaders really slow down?
Will the AI heavyweights actually slow the growth-at-all-costs push? The truth sits somewhere between two views: that they are benevolent and looking out for the best interest, and a fully cynical read. You do not call for more regulation in an area unless you are the leader trying to shield yourself from competition. They likely also have real concerns about how the technology develops.
This is a prisoner's dilemma from game theory: every player keeps pushing hard even though they know they should not. The best discipline here would come through funding. Higher cost of capital would rein in the excess. Consider the cost of solving the Navier-Stokes problem they celebrated - probably about $25 million, running 10,000 agents over 80 hours of work, to win a $1 million prize. More discipline from investors could go a long way toward curbing that kind of spending.
What a 25 basis point hike would do
If the Fed raises 25 basis points, it would make some problems worse, not better.
Fed chair Warsh's philosophy looks like a mix of monetarism, the classic kind focused on the balance sheet and money supply. He would likely prefer shrinking the balance sheet rather than leaning only on interest rates. Policy has swung too far toward treating the overnight funding rate as everything, when the balance sheet matters too.
A hike would make the K-shaped economy worse. The parts most sensitive to interest rates are lower-income people with floating-rate credit card debt and anyone financing a new home or a car - not higher-income consumers. A hike would not help manufacturing, housing, or refinery building. It would be somewhat harmful to the outlook, though not enough to be the thing that tips the economy into recession. It just will not make anything better.
