Fed Note

The Federal Reserve Open Market Committee decided to cut interest rates a third time, by another 0.25%, to a new range of 1.50-1.75%. As with the two prior cuts in recent months, this move was controversial. The economic community was mixed as to the underlying need for this continued easing, highlighted by the two dissents this time, by governors preferring to keep rates where they were.

The formal statement was little changed from September from a policy standpoint, but was simplified, which tends to follow Chairman Powell’s plain-language style. It noted that the labor market remains strong and economic activity continues to rise at a ‘moderate’ rate. Also noted again were strength in household spending, while business fixed investments and exports remain weaker than the FOMC would like. The term ‘act as appropriate’ has now been removed, which has signaled that this rate cut could be the last for a while (barring further economic deterioration).

The dashboard of relevant Fed variables continues to show mixed results, in keeping with the varied sentiment about the rate cuts:

Economic growth: Real GDP for Q3 came in at 1.9% this morning—a shade below Q2 results but slightly better than expectations—but well within the recent trend of tempered yet positive growth. Growth is not decelerating to the point of raising immediate recession fears, although the uncertainty surrounding global trade has no doubt raised the chances over the coming year or two. The tipping point is always unknowable, with the best estimates of recession usually occurring while an economy is in it, as opposed to prior. At the same time, due to the lack of traditional excesses, such as over-extended credit conditions and general business euphoria (quite the opposite for the latter), any eventual recession could be on the milder side. Aside from the anomaly of the financial crisis, this has been the tendency for recessions over the last few decades, due to a decline in manufacturing as a percentage of the overall economy, in favor of services. This is in addition to better management of inventories and data availability, which has tended to reduce more damaging ‘shocks’.

Inflation: Over the past twelve months, CPI has come in at 1.7% on a headline and 2.4% on a core basis, with the former driven primarily by price movement in crude oil. Core prices have started to pick up a bit after averaging right around the Fed target of 2.0% over the past several years, but the drift upward hasn’t been dramatic. This is relevant for a variety of reasons, not the least of which is tendency for long-term interest rates to remain anchored to inflation and economic growth expectations (lower levels = lower rates), apart from what the Fed can control on the short end of the yield curve.

Employment: Labor remains the long-running bright spot in the economy, with a decades-low unemployment rate, few signs of layoffs and continued low levels of jobless claims. The trajectory remains positive, which coincides with economic growth as opposed to recession, but economists are watching for signs of eventual year-over-year deterioration, which is one of the leading indicators for an ultimate slowdown. But there are no signs of this yet.

 

Recent Fed policy movements are unusual, but not unprecedented. In the simplest terms, waiting for and then responding to weaker economic data points, is the typical monetary policy protocol. In this case, the Fed has decided to preempt this by using ‘insurance cuts’, which hedge the bets of a negative outcome from trade policy impacts of tariffs and pullback in business capex spending.

Equity investors have tailored holdings in keeping with this broader uncertainty, with flows toward and higher valuations for more defensive segments, such as utilities and consumer staples, while cyclicals and other traditional ‘value’ stocks remain in the doghouse. While decent returns have masked it, U.S. stocks have experienced net outflows of $100 bil. so far this year (aside from the movement from active into passive equity funds), with bond funds and cash inflows approaching a third of a trillion and half-trillion dollars, respectively. As has been the case for far too many quarters, prospects for a U.S.-China trade deal have driven market sentiment in both directions, and have even affected central bank policy due to the potential impacts of slower global growth that could surface from the continued uncertainty. This has been echoed by estimates from sources such as the International Monetary Fund, which lowered expected growth by a few tenths to 3.0% for 2019, before an expected rebound to 3.4% for 2020. If such conditions continue, it might keep the Fed on an easing tendency, despite economic growth moving along at a pace that may otherwise warrant no action. Equities have tended to be rewarded by periods of easing and lower rates, while long-term bond returns tend to be tied to their starting yields (low in this case).

 

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