Fed Update

Fed Note:

The July FOMC meeting resulted in a 0.25% reduction in the federal funds rate, to a new range of 2.00-2.25%. The policy vote was far from unanimous, with eight members supporting the change, and the Fed presidents from Kansas City and Boston each dissenting. This reflects the varied commentary from members in recent weeks as to the necessity of the cut. This was the first rate cut since December 2008, when circumstances were obviously far different from those seen today.

The formal statement reflected the Fed’s newly-adopted dovish stance, notably the persistently muted inflation and ‘implications of global developments.’ The Fed also announced that it would end its balance sheet drawdown in August—two months before they’d planned. Other language was little changed from June, with economic activity noted as ‘moderate,’ and labor market as ‘strong,’ but inflation remaining low, and business fixed investment still ‘soft.’

This was a move largely expected by financial markets, although the magnitude of the move remained in doubt until recently, when fed funds futures odds pegged the smaller change at 80%. Current futures probabilities put the best odds at two additional cuts by December. Despite the change in tone this year, manifesting in today’s change, the primary Fed mandates remain somewhat conflicted:

Economic growth: The preliminary measure of 2nd quarter U.S. GDP came in at 2.1%, a notably slower pace than Q1, but in line with expectations. This slowdown was partially driven by weather effects, lower exports due to the administration’s trade policy, as well as ongoing weakness in business fixed investment. The latter has been noted as a key area of stubborn lagging growth by the Fed, and while qualitative reasons are difficult to measure, likely aren’t helped by corporate decision-making uncertainty based on the evolution away from freer global trade. In short, without knowing how tariff policy will affect business conditions and costs over the next several years, managers could be reluctant to budget large sums toward multi-year projects.

Inflation: Recent data puts core inflation at up to a half-percent under the Fed’s 2.0% policy target. While the lag has been described by Chair Powell and others in the Fed as due to ‘transitory’ factors, the persistent weakness seems to have some policymakers concerned or at least puzzled. When removing volatile crude oil price moves from the equation, factors such as higher healthcare prices and implied rents (measured from higher home prices) have been somewhat offset by cheaper technology and communications costs (at least partially integrated with the well-known ‘Amazon effect,’ but also mobile pricing plans, which are a growing portion of consumer budgets). It would be a stretch to say lower inflation by these measures has been a burden on consumers—resulting in lower prices for a wide variety of goods. However, traditional economists point to a lack of inflation pickup from wage growth and other measures as problematic and indicative of low structural economic growth.

Employment: Indicators here remain strongly positive, the best in several decades, whether it be the unemployment rate or jobless claims. While these levels would make a Fed rate cut seem counterintuitive on the surface, bordering on a policy mistake, one dark cloud about this point in the cycle is that great conditions don’t last forever. The better employment metrics get, and when they stabilize at such robust levels, the higher the chances of an eventual reversal. While obvious and inevitable, the timing of such a turn would be the much more difficult part to pin down.

 

As noted by today’s action, the path of interest rates going forward has become less clear (assuming it’s ever clear in the first place). While there are some economic headwinds, it’s been questioned whether their severity is enough to warrant an outright rate cut. Others believe the Fed didn’t do enough and wanted 0.50%. Only time will tell if this move was prophetically appropriate, or is eventually viewed as a ‘policy error,’ of which the Fed has been known to have made many times through the last century.

Some work by the Fed done recently attempts to measure the impact of ‘insurance rate cuts,’ such as those prescribed today. Interestingly, the evidence is mixed. Assuming the timing and amount of the cut is correct, they can help cushion effects of a downturn to some degree (such as high unemployment). However, there is also the potential for preemptive cuts to use up too much ‘dry powder’ for too little effect, or, even worse, act as an accelerant for existing or new financial asset bubbles. A key question some are asking at this point is: is it up to the Fed to stabilize financial markets? Others argue the U.S. Federal Reserve is becoming more of a ‘global central bank,’ in acting as a stabilizing force for not only growth concerns resulting from stymied global trade, but broader and deeper stagnation in Europe and Japan—not to mention the impact of an uncertain Brexit outcome. Is that the Fed’s job? It could be debated that if those events impact the U.S. economy, it could be.

There is also some non-trivial political risk between the Fed and the administration in the next year or two. The most difficult predicament for a sitting President staring at a re-election campaign is a deteriorating economy, or, worse, a recession. This has been the primary reason behind incumbents losing their jobs (think Bush Sr. in 1992 and Carter in 1980). It’s also been surmised that a more dovish Fed chair could take the place of current chair Powell, and keep rates low, although such action could undermine global confidence in the Federal Reserve’s independence. While unlikely in most instances, it is a potential risk.

For asset markets, lower rates tend to nurture bullish animal spirits. Aside from the positive duration impact on traditional fixed income as rates decline, equities and real estate benefit from a lower discount rate, which raises their theoretical fair values when viewed through cash flow and similar valuation models. Of course, if the Fed keeps its foot on the gas for longer than needed, such accommodation raises the risk of asset bubbles. When popped, the aftermath could be worse than it would have been letting the economy slow and take its natural course.

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