An uncomfortable connection between interest rate cuts and recessions was explored by Minneapolis-based economist James Paulsen in a recent Paulsen Perspectives newsletter.  

Seven of eight recessions between 1969 and 2020 were preceded by Federal Reserve change-of-direction rate cuts, Paulsen wrote. The only exception was the brief, and unique, two-month COVID-19 recession in 2020.

To be clear, recessions do not occur every time the Fed switches from raising to lowering interest rates, but it has happened enough in modern times to form a pattern of concern.  

So, what are the chances history will repeat itself following the Fed’s recent policy change?

Although Paulsen’s answer contains qualifiers, he makes the case against a recession this time. He bases that conclusion on several economic forces, including:

• Inflation. Price hikes were seemingly out of control a couple years ago for a variety of reasons related to the COVID-19 pandemic. But after spiking at 9.1% in June 2022, the consumer price index is now in the mid-2% range.   In each of seven U.S. recessions that followed Federal Reserve rate cuts between 1969 and 2009, inflation was climbing. But today’s lower rates come with “inflation at its back” instead of “blowing in its face,” Paulsen wrote.
• Productivity. In the past, “The Fed has often initiated easing campaigns when productivity was in the tank,” Paulsen reported. “Today, by contrast, productivity growth of 2.7% is stronger than the start of any other Fed easing cycle since at least 1968.” Nor does productivity appear to be cooling anytime soon.
• Corporate profits. One reason the Fed lowers rates is to strengthen businesses by lowering the cost of borrowing. When you track corporate profits as a percent of nominal GDP (gross domestic product), Paulsen said, past rate cuts were typically initiated when the profit/GDP index was at or below 8%. Today, that index is “near an all-time record high” of about 12%.
• Household debt. From the mid-1970s until 2008, U.S. household debt grew persistently, and every time the Fed eased rates, consumers’ debts reset at a higher level than during the previous cycle. But since the 2008 financial collapse, households have been eschewing debt. As a result, household debt today is near a 25-year low, which means U.S. families are “more recession resistant than ever,” Paulsen wrote.
• Corporate cash flow. Like households, the nation’s corporations also restructured balance sheets after the Great Recession of 2007-09 and now have stronger cash flows. Today, he said, corporations are holding more cash relative to overall economic activity than at the beginning of any other rate-cutting cycle.
• Consumer confidence. Consumer confidence is low, and as strange as it sounds, that may be a good thing. “Recessions are often made worse by a collapse in private player confidence,” Paulsen said. “Today, however, since pessimism is so pronounced, it seems unlikely confidence can decline much further.” In fact, consumer attitudes have begun to improve in recent months, and if that trend continues, it could “dramatically assist the Fed’s contemporary easing efforts,” he added.
• Unprecedented liquidity. “The Fed has recently embarked on a new easing cycle in an economy awash with liquidity,” Paulsen reported, noting: “There have never been more excess dollars relative to economic activity.” Those extra dollars, he said, are a cushion that was not available when other recessions began.

In a follow-up newsletter, Paulsen noted another anomaly: “This is the only bull market in post-war history where the Fed has (raised rates) during its entire existence.”

Until recently, he added, the market movers were a relatively small group of large cap and technology stocks. With lower interest rates, he predicted, smaller stocks from many sectors, which he called an “Everything Market,” will drive economic gains in coming months, as they have in recent weeks.  

Such broad-based participation normally occurs at the beginning of bull markets, Paulsen explained, but was held back until now by high interest rates. As a result, the narrow bull market of recent years was driven by positive economic growth and falling inflation.

But now with lower interest rates, small companies in diverse sectors are driving an “Everything Market.”