Long analysis: the case AGAINST cutting interest rates
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Today’s analysis will be a bit different than what you might have gotten used to during the past two years, and will focus on the macroeconomic and broader social impacts of cutting interest rates. I do believe you will find it interesting.
Before we dig into the topic, just a quick note on current market conditions. We are still very much in a bullish market, driven by both sentiment and positive buyer flows:
Volatility is still getting compressed, and we keep getting the gradual grind-up move we have been talking about for the past month and a half.
The best evidence of the bullish momentum is that even new tariff uncertainty failed to push markets down this week. The administration published new tariffs on Monday to several countries, and continued to do so for the rest of the week, culminating in yesterday’s notice of a 35% tariff on Canada. This did send markets down overnight, but the buying flows stepped in again on Friday, and we avoided any panic reaction. VIX is still below 17.
The impact of vol compression is likely to continue, at least until the new tariff deadline on August 1st. But before we even get there, we will get some additional information regarding the fiscal stimulus that might be coming from this administration - specifically, the decision to reduce issuance of long-term bonds, which would reduce their supply, and thus increase prices and push down yields on the long end (thus reducing borrowing costs for the government). This is very similar to what Yellen used to do during Q4 2023 and throughout 2024.
If this does happen - at the QRA meeting in the final week of July - it will create further bullish momentum for equities. If this is reinforced with a potentially dovish FOMC (signaling cuts in September), even tariffs won’t be able to bring down this market. At least not in the way they did back in April.
More on this in the next few weeks as we prepare for those policy decisions.
The argument against cutting interest rates
Since cutting interest rates has become the focal point of attention in markets, and since it has been given considerable attention by the current administration - it is time to do a deeper analysis into what this means and what kind of signals it sends.
Disclosure of interest: both personally and as the Fund, we would most certainly profit from cutting rates (the Fund would ride calls every week and deliver great gains to its investors, while I could get a cheaper loan for buying a flat in NYC). Still, I don’t think it’s the right thing to do to the economy in the long run.
Quick fixes for a strong economy?
Cutting interest rates sounds like an ideal quick economic fix – cheaper loans, boost for asset prices (especially real estate and equities), and potentially higher GDP growth. In the standard Wicksellian economic model - adapted by modern central banks across the world - when an economy is overheating, rates should go up to slow down economic activity, and when an economy is sluggish, rates should go down to prop up economic activity.
However, the present state of the US economy is incredibly strong, and has been like this ever since the Fed started to raise rates (Q1 2022), defying economic convention and avoiding a recession despite an inversion of the yield curve back in 2022. Dare we say the economy yearned for higher rates?
Even today, despite the initial tariff shocks, the US economy looks really good: GDP growth is at 2.6% (after a negative Q1 due to frontrunning on tariffs, growth has continued to be very robust echoing the levels from 2023 and 2024), unemployment is back down to 4.1%, demand for labor is still very strong, and inflation is arguably on a down trend. Nominal wages are still growing at higher rates than inflation (currently at 4.2%), so even though price levels remain elevated, which is still a burden on the consumer, business is booming in the US, and the economy seems to be in pretty good shape. There is concern over tariffs negatively impacting inflation in the short run, which seems to be the only argument the Fed has not to cut rates.
And although some cuts will happen this and next year (over time gradually bringing the rate down to 3.5% or 3%), I believe we are - in economic terms - far away from the zero rate environment everyone got used to during 2010s, and again after COVID.
Which is why it makes little sense for the administration to exert pressure on the Fed to cut rates down to 1.5% or lower (a 300 bps cut was advocated by Trump directly). This is probably what we might get next year, when the new governor steps in. But it would be the wrong thing to do.
I do understand why the administration wants to do this; it’s a quick fix, and it will create a short-term boost to an already overheating economy. On the other hand, lower rates would counteract the negative economic impact of tariffs - unless these tariffs generate sustained inflation. So it would be a win-win for the administration, they get to implement tariffs without creating negative economic consequences, thus completely avoiding a recession.
But is this really the case?
Kicking the can down the road
Similar to the budget bill (“Big Beautiful Bill”) that widens the deficit and generates a strong fiscal stimuli while kicking the debt can down the road, the monetary stimuli would generate the same effect - short term boost but huge structural problem ahead.
I wrote about the issue of becoming addicted to stimulus - this all started with the 2008 crisis and the initial set of QE policies which led to money hoarding from banks (exemplified by a large reduction in the velocity of money) and sluggish growth, until the system became addicted to low rates and more QE. During COVID we got QE on steroids, and are now facing a situation of very high debt levels and budget deficits (even higher than after 2009, when they were such a problem that they led to massive austerity policies). Only this time, the debt has to be serviced at rates of 4-5%, so it is becoming much more difficult to raise new debt for fiscal stimuli.
There are two scenarios when the economy becomes overburdened with debt:
Resort to unpopular economic policies like budget cuts, tax hikes, or deep structural reforms that lead to social tensions. This creates big problems in the short run: social tension, end of capitalism slogans, etc - but fixes things in the long run.
Engage in even more monetary and/or fiscal stimulus (rates down to zero, persistent QE) in order to simply kick the can down the road and avoid having to deal with reforms. Despite constant short-term boosts, this only weakens the economy in the long run and then it turns into Japan - three decades of stagnation. Or it implodes on its debt and is ravaged by creditors (very low probability of this happening to the US, but in most other countries which don’t have unlimited demand for their debt, this does happen).
There is also a third scenario, some massive productivity boom driven most likely by AI. This way, we get to grow out of our debt problem, and rates come down naturally.
The key emphasis is on naturally. By doing it artificially, we mess with fundamental price signals in the economy, and create distortions of capital allocation - in other words, capital starts flowing into unprofitable companies, rewarding business models that it should be punishing.
Historical examples
All this isn’t just theory – history provides plenty of warnings. I’ve been reading a great book The Price of Time: The Real Story of Interest, by Edward Chancellor - highly recommended reading, especially if you’re into economic history, the role of money, and monetary policy.
I’d like to summarize a few great historical examples from the book:
John Law in early 18th-century France. He flooded the French economy with easy money and pushed interest rates down to ~2%. It sparked a wild boom – land and stock prices (of his Mississippi Company) surged – and then an epic bust in 1720, An early example of how easy money lead to a hard landing. Based on this episode and many similar ones from the Victorian era or earlier (like the Tulipmania in Holland), banker-journalist Walter Bagehot noticed a pattern: periods of financial recklessness weren’t random – they tended to occur when money was easy and interest rates were very low. Investors, starved of safe returns, start “yield chasing” – taking bigger risks because they can’t “stand” ultra-low yields. In plain terms: whenever money is too cheap, it gets misallocated or misspent. This is also the standard conclusion of the Austrian School of Economics - artificially low rates lead to misallocation of resources.
Many of the biggest boom-bust episodes happened under low-rate regimes. The Roaring 1920s bubble before the Great Depression, Japan’s 1980s asset boom, and the mid-2000s credit binge before the 2008 crash – all were fostered by relatively low interest rates and mild inflation, which lulled central bankers into keeping the punch bowl out too long. Each of those credit booms ended in disaster.
Take the 2002–2008 housing bubble. In the early 2000s, the U.S. Federal Reserve slashed rates to then historically low levels (~1%). Cheap mortgages and easy credit fueled a housing frenzy – home prices skyrocketed, and debt piled up. Because consumer inflation stayed low, policymakers kept rates low, not realizing a dangerous bubble was inflating. By 2008, the bubble burst disastrously, triggering the worst financial crisis in generations.
Ironically, to fight the 2008 collapse (which was itself partly caused by cheap credit), central banks doubled down with even more rate cuts. They pushed interest rates to the lowest levels in 5,000 years of recorded history. In the 2010s, the U.S. and UK held rates near zero, and Europe and Japan even experimented with negative interest rates – essentially charging people to save. It was an unprecedented monetary experiment – “free money” on a global scale.
At first, ultra low rates seemed to work. Markets calmed, banks were recapitalized, and unemployment came down after 2008. These were the visible victories of easy money. But beneath the surface, problems were mounting - debt levels kept rising, the housing market went into another secular bull market, and misallocation was rampant. But it’s far greater than just debt and asset bubbles.
The unseen consequences of keeping rates low for too long
The long run consequences can truly be problematic for an economy. Several things happen that are initially unobserved:
Economic distortions: Rather than spark productive investment, near-zero rates often lead to a misallocation of capital. Companies that would normally go bankrupt (so-called “zombie” firms) can survive by endlessly rolling over cheap debt, dragging down productivity. Creative destruction gets thwarted, and capital flowed into dubious projects instead of more productive uses. At the same time, investors desperate for any return take on too much risk (because when money costs next-to-nothing, even shaky bets look tempting).
Asset bubbles, inequality, and resorting to populism: Ultra loose policy turbocharges asset prices. Stocks, real estate, crypto – everything shoots up. That’s fine if you own assets; your portfolio balloons. But if you’re a renter or a young person trying to buy your first home, tough luck (crypto leveled the field a bit for younger generations on average, but not across the board obviously). Houses become unaffordable for many, as cheap mortgages allow prices to leap far faster than wages. Meanwhile, wealth concentrates at the top. Those who have assets see big gains, while those who don’t get left behind – worsening the wealth gap. Just look at the consequences of low rates over the past 15 years and how they have added to social tensions between the asset holders and debt holders. This is the prime cause of seeking radical political change, both on the left and the right.
Savers get punished: Low rates also carry a stark fairness issue. People who spent years working and saving suddenly find that their savings earn almost nothing. The Fed’s zero-rate policy basically broke the social contract for generations of hardworking Americans who did the prudent thing, only to see their bank deposits and bonds yields get eaten up by inflation post COVID. Many retirees were forced to dip into principal or take on riskier investments just to survive.
Financial fragility: Cheap money can make the whole financial system more fragile. Banks, for example, loaded up on long-term bonds when rates were super low – seeming safe at the time. But when rates eventually rise, those bonds tank in value, threatening banks’ balance sheets. Regulators, in hindsight, admitted they “failed to comprehend how ultra-low interest rates ‘get into all the cracks’, creating myriad faultlines” in the system. All that hidden leverage and risk-taking shows itself only when the tide goes out.
We’re now living through the hangover of low rates, still being addicted to them like junkies. The remedy cannot be cutting rates again. The remedy cannot be more fiscal and monetary stimuli. It will only exacerbate all of the aforementioned issues. And push us not into a mere recession, but a much worse economic fallout in which we will no longer even have the answer how to fix things. This is when societies crumble under the pressure of debt, social tension, populism, and violent internal conflict.
I like to maintain an optimistic note and believe that this will not happen in a trial-and-error democracy for the reasons that are too long to elaborate in this blog. But I do feel that resorting to policies of cutting rates back to 1% or lower will be a terrible thing in the long run for all our economies. I would rather see rates stay high and trigger a recession then a compounding effect of asset bubbles, distortions, inequality and populism. Politicians, however, would certainly disagree.
Thanks for reading!
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Awesome read! I just don't see any future US leaders being interested in actually lowering the debt instead of increasing it. Triggering a recession isn't good for getting votes. Interesting times ahead!