Cut 25 basis points and Buy Some Optionality

The FOMC will cut the funds rate by 25 basis points next week. The case for a cut is clear, if not  overwhelming. 

▪ The principal motivation is risk management in the face of asymmetric downside risks around a modal forecast that has not shown any signs of recent further deterioration. 

▪ The case for a cut is strengthened by the zero bound problem, which reinforces the case for being  preemptive. 

▪ It’s also relevant that inflation has been persistently below 2%, notwithstanding the widely held view that the recent softness is mostly temporary. 

▪ And the concern that inflation expectations have eroded, or are likely to if inflation continues to be below the objective, is even more serious today than they worry inflation will not rise to 2% as soon as anticipated. 

▪ Still, the case for a cut next week has not become more compelling in recent weeks. The economy is— as Powell, Clarida, and Williams keep telling us—in a “good place.” 

The key to the communications next week—both the statement and the press conference—is buying optionality for near-term monetary policy. 

▪ The FOMC has no option but to cut next week, and by 25 basis points. To be clear: They want to. But at this point, they’ve also boxed themselves in. 

▪ If the FOMC wants optionality going forward, it has to communicate accordingly. Very tricky. They probably prefer a pretty neutral statement and press conference and to let the data and subsequent communications guide expectations. 

▪ We see a couple of relatively small revisions to the statement as the first step. The second step will be clarification or reinforcement of data dependency at the press conference. However, we also discuss alternative approaches should the FOMC opt for a more hawkish or dovish message. 

There are also some plumbing issues to be considered. 

▪ Continuing to passively tighten while actively easing is not ideal. Powell essentially said balance sheet policy would be adjusted accordingly.  

▪ We expect IOER to be adjusted in parallel with the fed funds target range (no additional relative  adjustment). 

▪ We expect more progress to be made with the configuration of a standing, fixed-rate repo facility, but no firm announcements. 

The Outlook Context 

Is the Economy in a Good Place? Yes. 

In terms of the real side of the economy, real GDP growth last year was revised down to 2½%, but that’s still comfortably above trend. Growth in the first half of this year was also 2½%. Not too hot and not too cold. The unemployment rate is very low, nearly a 50-year low. Employment growth remains at a pace well above that consistent with a stable unemployment rate. What’s not to like? This is a reason cited by a few participants who have indicated that they would prefer not to ease in July. 

On the other hand, inflation has been persistently low during this expansion. The most recent monthly data have looked a bit firmer after a string of weak prints early in the year, but today’s core inflation data from  BEA (quarterly through Q2) were soft. It looks like 12-month core PCE inflation will still be 1.6% in June. As for inflation expectations, both the survey-based and market-based measures have been soft, notwithstanding some improvement in both since the June meeting, and there is some concern that inflation expectations may erode if inflation remains below 2%—if they haven’t already.  

What about the forecast? Pretty good in the near term, but with some questions. 

The forecast for some time has pointed to slowing growth this year, from near 3% last year to 2% or somewhat higher this year, with some further moderation in growth over following years, which in turn would eventually be accompanied by a slight rise in the unemployment rate. After the NIPA revisions, the trajectory of real GDP and final private demand over the last six quarters or so looks somewhat different. On a four-quarter basis, real GDP growth through Q1 was marked down ½ percentage point, with real final private demand growth marked down a couple of tenths.  

Real GDP growth will almost certainly be slower in the second half after advancing at a 2½% rate in the first half, but final private demand still seems likely to grow at a decent pace. Fears of a more abrupt slowdown have not been realized. Recent data on manufacturing and core capital goods orders have been somewhat better. In any case, consumer spending has been doing the heavy lifting, particularly in Q2, in which both residential investment and business fixed investment declined, and the fundamentals remain supportive of continued growth in that area.  

But doesn’t the budget agreement change all that? No. 

On the surface, it might appear so, when you see that spending levels have been raised substantially above what previous legislation indicated. But the budget agreement is roughly what we had been assuming would happen. It seemed implausible that they would allow spending levels to fall drastically, as would have happened had the sequestration caps been allowed to become binding. Spending has indeed been boosted for the fiscal year 2020 relative to this year, but actual outlays (what matters for the forecast)  significantly lag increases in budget authority. The biggest effect this deal has on the forecast is to remove a  source of downside risk—the possibility of more contentious negotiations involving brinksmanship over raising the debt ceiling and perhaps another federal government shutdown. 

Is there room to grow above trend without excessive inflation? Apparently. 

First, the Phillips curve is very flat. Second, the NAIRU may be lower than the current median estimate,  perhaps where the unemployment rate is today, as Clarida and Powell have both hinted. 

Powell said: “I would look at today’s level of unemployment as well within the range of …plausible estimates  of what the natural rate of unemployment is.”

In any case, the FOMC seems prepared to test the limits here, as it celebrates the social benefits of a low unemployment rate and tight labor market.. 

Still, doesn’t the persistent undershoot of 2% raise a question as to whether inflation will return to 2% over the forecast horizon? Yes. 

First, inflation has been persistently below 2% for a long time, underperforming projections by us and by  policymakers. Still, it did reach 2%, if only for a few months, in 2018, before relapsing. In any case, it was at least moving to the edge of 2%. But soft numbers earlier this year lowered the 12-month rate—a lot—and raised some concern. 

It is widely believed that the recent softness will prove mostly temporary. “Mostly” is the keyword. There’s some support for that in the recent data. The incoming price data for the last few months have been firmer,  sure, suggesting that on a quarter-on-quarter basis core PCE inflation might have picked up to 2% in Q2. But that Q2 print was a disappointing 1.8%, and the Q1 reading was marked down further, from 1.2% to barely rounding up to 1.1%. It looks like 12-month core PCE inflation will remain at 1.6% when we get the June print next week.  

Are inflation expectations eroding? Maybe. 

We believe that perhaps the major concern of FOMC participants today is that either inflation expectations have already eroded or that they will if inflation remains below 2%. Clarida made an interesting comment  about inflation expectations: “indicators suggest that longer-term inflation expectations sit at the low end of  a range that I consider consistent with our price stability mandate.” 

For the measure of longer-term expected inflation from the Michigan survey of consumers, we see figures between 2.7% and 3.2% as having been consistent in the past with the FOMC’s inflation objective. The  FOMC follows this indicator closely. The survey measure has been bouncing around recently between 2.2%  and 2.6%. Most recently, it’s bounced back up to 2.6%, which is fine, since it is consistent with about 2%  PCE inflation and consistent with Clarida’s remark. Were it to settle at 2.2%, however, that would be a  different story. 

Market-based measures of inflation compensation (comparable to a measure of inflation expectations) have been below levels we have seen as consistent with 2% PCE inflation. They declined further in the run-up to the June FOMC meeting, leading to a mention in the FOMC statement. Since then they’ve stabilized, at least not declining further. Some have viewed around 2½% as the sweet spot for the five-year, five-year forward  BEI rate. This measure does suggest some erosion. But it is volatile and reflects considerations other than inflation expectations—liquidity and risk premia, so the conclusion that inflation expectations have declined is not definitive. Still, some participants believe that inflation expectations have eroded and much more are concerned that this will happen if inflation continues to linger below 2%.  

Is the yield curve signaling recession? No. 

But it is signaling a materially higher risk than earlier in the year. Our probit model shows an increase in the probability of recession over the next year as having risen from below 20% in recent quarters to about 50%  today. That’s below the levels that have preceded previous recessions but getting closer. Worth watching,  as Clarida has said. 

Aren’t there serious downside risks? Yes

But they are risks relative to a mostly favorable baseline, and so not reflected in the modal forecast. If they materialize, the forecast would likely be revised downward for growth and upward for the unemployment rate. The budget agreement removes a source of downside risk that the FOMC has been including in its risk assessment. But the probability of a hard Brexit has increased, though the risk with respect to U.S. growth is likely not large. Escalation in trade tensions with China, specifically another round of tariffs, would likely sharpen the slowing in the U.S. economy. 

FOMC Call 

We continue to expect a 25-basis-point cut at the July meeting. This is what the overwhelming majority of participants want or are willing to go along with. In our view, this is both the consensus of participants and what the leadership wants (meaning Powell, Clarida, and Williams). A few would prefer no cut. Just a couple have supported or might support a 50-basis-point cut. Of course, given the gyrations in the markets last week, many of us will be relieved to read that it really is 25 basis points! 

We expect the key message from this meeting—in the statement and the press conference—will be about preserving optionality. Cut next week, and then let the data speak. 

Why ease?  

▪ Risk management with the unchanged modal forecast. Brainard: “While the modal outlook is solid, the downside risks, if they materialize, could weigh on economic activity. Taking into account the downside  risks at a time when inflation is on the soft side would argue for softening the expected path of monetary  policy according to basic principles of risk management.” 

▪ Be preemptive and aggressive when facing the zero-lower-bound problem. Williams: “take swift action  when faced with adverse economic conditions.” Clarida: “an important part of monetary policy is not only  setting policy for the baseline but also doing risk management considerations.” 

▪ Priority is extending the expansion. Easing too much could result in overshooting the 2% objective  (eventually) and require a potentially painful tightening later on. Not easing could lead to a slowdown sharper than already expected. After the last recession and the long period of below-2% inflation, it’s not surprising that the Committee has set a priority on keeping the expansion going. The risk of unacceptably high inflation seems negligible.  

▪ Inflation persistently below 2%.  

▪ Desire to push inflation above 2%. Evans: “Before we even talk about more trade uncertainty I’m a little  more inclined to think we might wonder if we’ve got the appropriately accommodative setting to generate  inflation at 2, 2.25%.” 

▪ Erosion of inflation expectations.  

Why shouldn’t they ease?  

▪ The economy is in a good place! Clarida: “The U.S. economy is in a good place.” Williams: “The U.S. economy  is growing really nicely.” Powell: “The economy performed reasonably well over the first half of 2019,  and the current expansion is now in its 11th year.” 

▪ Soft inflation is temporary. If you’re patient, inflation is likely headed back toward 2%. Clarida: “It has been moving away this year. We think some of that is transitory.” 

▪ Perhaps inflation expectations have not yet eroded. Clarida: “As I assess the totality of the evidence, I  judge that, at present, indicators suggest that longer-term inflation expectations sit at the low end of a  range that I consider consistent with our price stability mandate.” 

▪ NAIRU may be lower, near the prevailing unemployment rate. Powell: “I would look at today’s level of  unemployment as well within the range of plausible estimates of what the natural rate of unemployment  is.” 

Why ease by more than 25 basis points? 

Only a couple (Kashkari and Evans) have made an explicit case for an immediate 50-basis-point cut: Evans  noted: “There is an argument that if I think that it takes 50 basis points before the end of the year to get  inflation up, then something right away would make that happen sooner.” 

Why ease only 25 basis points? 

▪ It’s the consensus. Supported by most participants, even if individuals might prefer no easing or more easing. It is also between the two extreme cases of zero and 50 basis points. 

▪ But the motivation is principally risk management with an unchanged modal forecast.  ▪ This easing is merely a recalibration of policy, not about an immediate recession scare.  

Will the Statement Be Revised to Preserve Optionality? Yes 

We have thought that the most important role of the language in the statement and the press conference would be to buy optionality. But that is hard to do. Perhaps best to be perceived by the market as being neutral, though that can also be hard to do! 

Not much change, if any, to the first two paragraphs on information received since the last meeting and on the outlook. The key language is, of course, to be found in paragraph three which provides guidance, if any.  Here the precise wording may be less important than the direction of the change. 

How will they characterize the likelihood of rate cuts to follow? 

The statement and press conference are valuable tools for the FOMC and Powell to jointly shape market expectations for the policy path going forward. We essentially assume that Powell has the broad support of the FOMC for a 25-basis-point July cut (notwithstanding a likely dissent from Rosengren). But signaling too strongly additional further easing in the near term is likely to provoke intense disagreement among a significant minority who still had doubts about a July cut but went along anyway.  

It depends heavily on the prevailing market expectations for another easing in September (or later). Currently,  the market expects better-than-even odds of a September rate cut after a July cut. With that in mind, the statement and press conference will be careful to strike a balance between (a) pushing back too hard against those odds, creating undesirable market whiplash, and (b) encouraging the market to price in even more aggressive easing. 

The statement can be quite versatile in this sense. Our baseline is quite conservative, in that we think the  FOMC will be very careful to avoid any further encouragement of expectations of a September rate cut. But if they agree on endorsing market odds of a September easing, they could do so quite easily in the second paragraph following the sentence on the new fund’s rate target, for example by emphasizing downside risks.  Such hints could also be indirect, such as any additional emphasis on “global” risks. Any such hints seem unlikely to come in the first paragraph. To the extent that “act as appropriate” has come to signify easing,  the FOMC would be especially careful changing that language. Omitting it would certainly be interpreted as a rejection of further easing in the near term; on the other hand, enhancing it might further support expectations of a September cut or a cut of greater size. 

The press conference, too, will be scanned for hints about how much time the FOMC needs to assess whether the July cut will suffice and what the hurdle is for further action. His prepared remarks offer a valuable opportunity to expand on the nuance of the statement, for example, if the initial market reaction points to an interpretation of the statement that is too dovish. In that case, Powell could tilt the message more strongly toward the insurance nature of the cut and point to the strong labor market and consumption data. But if the  statement is ultimately received as being too hawkish, then Powell would point to a confluence of downside 

risks (especially global trade tensions and Brexit) as depressing forces. But he will take great care not to go too far. He will avoid encouraging market expectations of a September rate cut of more than 25 basis points. 

In June, Powell provided more color on the views of FOMC participants on the outlook and the possibility of easing than we are used to getting at the press conference. We usually only get that sort of detail several weeks later, in the minutes. Given that the June dots showed so many projecting 50 basis point in cuts by the end of the year, this might be especially important for this meeting, as there are no scheduled SEP macro projections and a dot plot to explain the rate cut and how views have changed.  

The First Paragraph of the Statement 

Much of the language in the first paragraph of the June FOMC statement still works. In most parts, there are likely to be only tweaked. With Q2 real GDP growth coming in at 2.1%, the pace of economic activity still  qualifies as “moderate.” We don’t think they need to talk about moderation from a stronger Q1 pace,  especially since final private demand growth went in the opposite direction between those two quarters. No  need, or reason for, a substantive change in the language on the labor market, 12-month inflation, or survey 

based measures of inflation expectations. As discussed above, market-based measures of inflation  compensation have moved up a bit, but largely moved sideways, since the last FOMC meeting, so they’ll no  longer say they’ve “declined.” But they still “remain low.” The part of the first paragraph where we see the  FOMC as having the most latitude is the language on household spending and business fixed investment. We think they’ll be fairly matter-of-fact about the Q2 GDP data now in hand. Last time, they said household  spending “appears to have picked up from earlier in the year.” The Q2 data confirmed that, so they can say  household spending “picked up in the second quarter.” Business fixed investment, on the other hand, declined in Q2, though some recent forward-looking indicators have been better. We think they’ll opt to stick with the  general term “soft,” but, as with household spending, be a bit more definitive, in this case by removing the  references to “indicators of business fixed investment.”

Our Guess of the Statement 

Information received since the Federal Open Market Committee met in May June indicates that the labor market remains strong and that economic activity is rising at a moderate rate. Job gains have been solid,  on average, in recent months, and the unemployment rate has remained low. Although While the growth of household spending appears to have picked up from earlier in the year, in the second quarter, indicators of business fixed investment have been soft has been soft. On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation have declined remain low; survey-based measures of longer-term inflation expectations are little changed. 

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In light of increased uncertainties continuing to weigh on the outlook and muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 2 to 2-1/4  percent. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. Nevertheless, the Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2  percent objective as the most likely outcomes, but uncertainties about this outlook have increased. In light of these uncertainties and muted inflation pressures, The Committee will continue to closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective. 

In determining the timing and size of future adjustments to the target range for the federal funds rate, the  Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. 

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice-Chair;  Michelle W. Bowman; Lael Brainard; James Bullard; Richard H. Clarida; Charles L. Evans; Esther L.  George; Randal K. Quarles.; and Eric S. Rosengren. Voting against the action was James Bullard, who preferred at this meeting to lower the target range for the federal funds rate by 25 basis points Voting against the action was Eric S. Rosengren, who preferred no change in the target range for the federal funds rate at this meeting. 

Will the FOMC end runoff earlier than previously indicated? Probably 

The market should not be too surprised if the FOMC announces it is sticking to its guidance that it will end runoff in September. (A few regional Feds have endorsed this view.) But without any change in runoff policy,  the Committee would face the tension of actively easing (decline in the fund’s rate) while continuing to passively tighten (continued runoff). That is not a desirable configuration. This consideration suggests the  FOMC might end runoff after this meeting, which is only slightly earlier than the September end that has been communicated. Although several regional Fed leaders Powell said in June: “If we do provide more  accommodation, we’ll certainly keep in mind…that we’ll always be willing to adjust balance sheet policy so  that it serves our dual-mandate objectives.” That is a suggestion that the FOMC would consider ending runoff early with a July cut. 

Potential for Dissent: One, Maybe Two 

Given that a minority of policymakers are uncomfortable with the notion of easing rates at all, it is possible that the statement will include one or two dissents from voters, the most likely dissenters being Rosengren and George. However, George recently expressed more openness to a small adjustment in the fund’s rate. We don’t expect the number of dissents to change our view of the policy outlook. 

IOER 

We expect IOER to be adjusted by a full 25 basis points, in parallel with the fund’s rate cut (no additional relative adjustment, in other words). Given that the effective funds rate continues to trade “well within” the target range, a further downward adjustment in IOER is not urgently needed. 

Standing Repo Facility 

We expect more progress to be made with the configuration of a standing, fixed-rate repo facility. However,  the establishment of a standing repo facility might not be sufficient to mitigate fully the dislocations in funding markets at the ends of months and quarters. Policymakers seem to be in the initial stages of evaluating such measures but further progress could be made in the following months. An alternative would be conventional open market operations, although policymakers seem to have a limited appetite to return to those. Ultimately,  the Fed would like to enforce a stronger cap on the effective fund’s rate and other money market rates. But they are still working through the optimal design of the program (level of fixed rates, eligible counterparties, and collateral). Powell may allude to further discussions on this front, but we don’t expect any substantive news.

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