Following their June meeting yesterday, the Federal Open Market Committee (FOMC) made no change to the 2.25-2.50% range for the fed funds rate. However, member appeared split on the outlook, with one member voting for a cut today, while others expect cuts towards the end of the year. This does seem to raise the probability significantly for a cut in July or September.
The formal statement reflected a change in economic growth from ‘solid’ to ‘moderate,’ and although household spending has picked up, business capex spending has remained soft. The inflation picture was acknowledged as weakening, while long-term expectations remained unchanged. As expected, the term ‘patient’ was removed, with concerned noted about a variety of ‘uncertainties.’
This was largely as expected, although in recent weeks, futures markets had begun to price in a 20-25% chance of a quarter-point cut at this meeting. The odds for a rate cut down the road, though, have risen sharply, with December futures implying probabilities for 2-3 cuts by year-end, and more in 2020. This seems a bit extreme on the surface, but markets do tend to overshoot, with the fed funds assumption markets being no exception.
The narrative, at least from the market’s perspective, has certainly changed, with the possibility of easier monetary policy rising in light of a possible longer trade negotiation with China and the ramifications of imposed tariffs in the meantime resulting in global slowdown risks. However, in recent speeches, the Fed hasn’t alluded to cutting rates specifically—merely that they would do as they always do and ‘act as appropriate’ to stabilize the economy. This is particularly tricky now, though, with economic conditions continuing to show modest expansion for the most part, but with greater uncertainty on the margin, so the Fed has been put into a bit of a corner. Historically, merely seeing potential for slowing hasn’t been a clear path to rate cuts without concrete reports of deteriorating data. This is in contrast to hopes by some for ‘insurance’ cuts, which would presumably be made as a hedge against bad outcomes that may or may not unfold—a strategy that the Fed hasn’t generally used. The President’s continued calls for lower interest rates to sustain the economic expansion have also represented a political (and an integrity) burden on an otherwise independent entity.
The current conditions of the Fed’s primary mandates reflect a similar conflicted message:
Growth for Q2 is not likely running at the strong one-off pace of some recent quarters, estimated by the New York Fed to be 1.4% and Atlanta Fed at 2.0%, with a few higher estimates by private-sector economists. While quarterly fluctuations will vary based on inputs like inventory buildup and weather, longer-term growth remains tied to demographics/labor force changes and productivity. Those have remained dampened, and despite what monetary/fiscal policy can muster, are difficult to push beyond a realistic band without structural shifts in their long-term trends. Fears, of course, lie in the possibility of a lengthy U.S.-China trade battle and ramifications on global growth (slowing it, perhaps dramatically), which would certainly filter through to slower U.S. growth. Politics aside, a recession is still not the base case according to several well-regarded economists. In looking at other economic conditions indicators, a strong stock market has helped, while a strong dollar has hurt somewhat.
The most recent report showed year-over-year CPI falling to 1.8% on a headline basis and core holding steady at 2.0%. Adjusting the composition around the Fed-preferred PCE index, it is a bit below target, perhaps by up to a quarter percent, where it has stood for an extended period. While the Fed would like inflation to run a bit hotter, lower levels have been blamed on ‘transitory’ factors (such as volatility in commodity prices), which concerns them less. However, any more persistent deflationary forces could move the needle towards a rate cut(s). In fact, recent FOMC member comments were interpreted that inflation falling to 1.5% represented a line in the sand for this to happen, but that remains speculation. On the other hand, economists have been slicing and dicing the sub-components of various indexes themselves, using ‘trimmed mean’ (removing the outliers) and other measures to find a better real-time gauge—some of which show inflation has started to slowly pick up ‘on average.’ Nonetheless, the stickiness of low inflation remains a problem for the Fed.
For some time now, the bright spot in the economy has been labor, and still is to a large degree, although some data points have recently flattened. The disappointing May payroll number spurred worries, despite that report’s wide room for error and tendency for large revisions. It’s also possible that severe weather in the Midwest/South may have depressed the data, so future reports will be important to determine trend. Other metrics such as JOLTs (job openings and labor turnover survey), the unemployment rate and jobless claims remain strong, so it would likely take a sustained deterioration to reverse the current multi-decade peak in conditions. Therefore, it would seem less likely that labor would be used as an excuse to cut rates.
Following the V-shaped movement of markets from Q4 of 2018, through Q1 of this year, and in recent months, financial market sentiment remains heavily focused on the two intertwined elements of Fed movements and U.S.-China trade—due to their global growth implications. Shorter-term resolution of the tariff spat may play as large a role in risk market volatility as anything else, and this uncertainty remains a major wildcard, with strategists still hesitant to handicap the various scenarios. By the end of this month, the past ten years since the financial crisis will have represented the longest U.S. economic expansion on record. While it appears it may continue for the time being, markets and economists are obviously much more sensitive to signs of deterioration than they were a year or two ago.