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Investment outlook

Fed shaves a little more off the top as trade risks rise

Brian Nick
Chief Investment Strategist
Fed reserve building
The Federal Reserve has once again cut its policy rate target. In the six weeks since the last meeting, global trade risks have risen as the U.S. and China have placed new and higher tariffs on each other’s goods. While U.S. economic data remains generally solid, the Fed remains wary of weak global and trade-related uncertainty, and may reduce rates further.

What happened?


The Federal Reserve (Fed) followed up its 25 basis point (bps) cut in July with another in September. The federal funds rate target range now stands at 1.75% − 2.00%. Similar to the July cut, futures markets had already priced in the move prior to the meeting. A shaky August for financial markets and several more rounds of escalation in the U.S./China trade war pose risks to U.S. growth, and the Fed will view today’s measure as prudent to ensure the expansion continues.

The statement released after the meeting contained relatively few changes, but mentioned that exports had weakened along with business fixed investment. Notably, there were three dissents from Federal Open Market Committee (FOMC) members. Two members did not feel the cut was necessary, while one would have preferred a larger cut. Dissents in opposite directions are relatively rare, underscoring the division on the committee.

The Fed’s summary of economic projections was little changed. It sees GDP growth decelerating from 2.2% in 2019 to 2% in 2020 and below 2% in 2021 and 2022. It also forecasted little change in unemployment or core inflation in the near term.

The so-called dot-plot of interest rate projections showed an unusual amount of division in the FOMC about where interest rates should go next. Five members did not believe today’s cut was necessary, while twelve did. Of those twelve, seven – a minority of the overall committee – see one more cut this year. No members foresee more than one further cut over any time horizon.

In his press conference, Chair Powell sounded upbeat about the economic outlook, particularly the U.S. consumer and the jobs market. He once again described today’s rate cut as insurance against trade uncertainty and weak global growth leading to a more severe U.S. economic slowdown, not as the second step in a longer easing cycle.

Are more cuts on the way?


The U.S. economy has low unemployment, rising average incomes and strong consumer spending. Core consumer price inflation is 2.4% and has been trending higher in recent months. Based on its mandate alone – full employment and price stability – the Fed would likely not reduce interest rates beyond these two small cuts. However, failure to meet the new standards that Powell and his colleagues have laid out at recent meetings – stable global growth and reduced policy uncertainty—could lead the Fed to cut again before the end of 2019.

Just prior to the meeting, futures markets were pricing in a 72% chance of at least one more cut this year and a 26% chance of two. By the end of Powell’s press conference, those odds had fallen to 68% and 18%, respectively. There is precedent for the three-cut mid-cycle adjustment. During the 1990s, the Fed undertook two mini-easing cycles in which it cut rates three times each, or 75 bps. In both cases, it subsequently raised rates as the economy regained its footing.

Whether the Fed cuts again this year as further insurance against a recession, we don’t expect deeper cuts into 2020 absent a more severe slowdown in growth. In our view, the markets are pricing in too high a chance that the federal funds rate will fall further next year.

What effect will these cuts have?


It’s easy to observe the market effect of today’s announcement. While the move was largely priced into markets, the FOMC’s divided outlook was interpreted as hawkish, pushing interest rates and the U.S. dollar up and stock prices down in the wake of the meeting.
 
It’s harder to measure the longer term impact of a 25 bps rate cut on the broader economy. Central banks lower interest rates in times of stress to promote easier financial conditions, including credit growth and market liquidity. At the moment, however, financial conditions already appear to be quite loose. Long-term interest rates are near all-time lows, corporate credit spreads are narrow and equity valuations are well-supported. Markets appear to be functioning just fine, with most of the volatility occurring on days when new tariffs or tariff-related retaliation are announced.

It may therefore be the case that the current round of interest rates cuts, while cheered by investors, will prove less effective at stimulating U.S. economic activity. A U.S. company with a global supply chain may be foregoing new investments until at least a semi-permanent trade deal is struck between the U.S. and China. It’s not at all clear that lower interest rates will make those new investments attractive enough to undertake while policy uncertainty still looms.

What other announcements did the Fed make?


In addition to reducing the fed funds rate, the Fed also reduced several rates it uses to help keep interbank lending markets running smoothly. Chair Powell was asked about the recent volatility in repo rates, which are used to price short-term collateralized loans between banks. Repo rates generally trade close to the fed funds target rate, but earlier this week they spiked much higher, a sign that lack of liquidity had become an acute concern.

One of the Fed’s challenges in the coming years will be to estimate how big its balance sheet needs to be, i.e., how much liquidity it needs to provide to U.S. banks. The Fed was able to calm the repo market this week by providing short-term injections of liquidity. But as Powell acknowledged, over time the Fed will likely have to allow its balance sheet to expand slowly, something it did routinely before 2008. Demand for cash grows over time with the size of the economy and the financial system. This means the Fed may ultimately need to resume regular open market purchases, not to stimulate the economy by providing excess liquidity, but to ensure the banking system has proper amount of liquidity.

We don’t expect a major market impact if the Fed returns to its routine balance sheet expansion. But the consequences of failing to anchor interest rates on interbank trading could eventually spill over into broader fixed income markets, something the Fed will want to avoid.




Endnotes

Sources
Federal Reserve Statement, September 2019.
Bloomberg.
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Glossary
A basis point is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.
The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy and assess the risks to its long-run goals of price stability and sustainable economic growth.

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