Cut 25, But Why?

We expect the FOMC to cut the funds rate by 25 basis points in October. The interesting questions are why and what happens next! 

▪ The “we’re in a good place and the outlook is favorable” camp seems, if anything, stronger, implying that rate cuts are now a meeting-to-meeting decision, dependent on the incoming data. ▪ While the move could still be characterized as risk management, after two cuts, and with some of the worst tail risks arguably reduced (hard Brexit, severe escalation in U.S.-China trade war, U.S. economy already entering recession), the case for further risk management cuts may also have diminished. ▪ A few are receptive to further accommodation because of concern that inflation will remain below 2%  for some time, that inflation expectations may be eroding, and that the slowdown appears to be sharper than expected, as indicated by participants’ median projection from the September meeting. ▪ And then there’s the market. Once again, it insists. And the FOMC has not pushed back. This may well be what cements the decision to cut again. 

What’s next? A long pause—indeed through the rest of the forecast horizon—and a softish landing. At least as a base case. 

▪ “Is a soft landing through 2022 credible?”, we hear you say! Perhaps not. But if the realization of the already visible downside risks does not push the economy into a recession by mid-2020, we don’t know why or when. 

▪ Still, the prospect of below-trend growth in 2020 and 2021 threatens a slide into recession. That, in turn, brings the potential that the funds will be constrained by the zero lower bound sometime during this interval. 

▪ It is a close call as to whether the economy slows more sharply than we and participants expect. If the labor market weakens sooner and by more than we expect, that would call for additional easing. 

The focus on Wednesday will, of course, be the communication—the statement and press conference. In particular, the question will be whether the FOMC succeeds in buying optionality by more persuasively and convincingly arguing that this really is a meeting-to-meeting story, totally data-dependent so that the market accepts that there is no presumption of further easing in December. 

▪ To be sure, the narrative to this point has already been that the economy is in a good place, the outlook is favorable, and policy is data-dependent. But markets weren’t really buying that in the lead-up to previous meetings. 

▪ However, the market seems to have changed its perspective recently. For example, recent data disappointments haven’t led to speculation of a 50-basis-point cut next week or to significantly higher probabilities of a December cut. Given that the market-implied probability today of the fourth cut in  December is less than 50%, it would be a success if it stayed that way or didn’t go much above 50%. 

▪ The narrative in the press conference might be that the Committee now believes that they have taken the appropriate insurance for asymmetric downside risks, and, in any case, that the likelihood of some of the most severe outcomes seems to have diminished. Going forward, decisions will be made on a  meeting-to-meeting basis and be data-dependent. Truly “wait and see.” 

OUTLOOK CONTEXT 

There are at least three ways of looking at the economy, reflected in differing sentiment within the still-divided  FOMC. 

1. The first camp emphasizes that “the economy is in a good place.” That’s about initial conditions. Who could argue with that? Also, that the outlook is favorable. Sure, a soft landing. Support for further  cuts is conditional on the incoming data pointing to a slowdown that is sharper than expected. The  mantra: “It depends.” 

2. A second camp does not dispute that the economy is in a good place or that the forecast is favorable.  Nonetheless, they supported buying insurance against asymmetric downside risks and responding to a slowdown that is sharper than expected due to spillovers to the U.S. economy. Some of those think the two cuts have bought enough insurance. 

3. A third camp, the smallest, does not see initial conditions as optimistically. They focus on low inflation. They are concerned that inflation may remain below 2%, that inflation expectations are eroding, and that the economy is slowing or will slow more sharply than the median projection. 

We see the first camp as having gotten larger, the second camp as having gotten smaller, and the third camp as having just a few members. Watch for the third camp, focused on slower-than-expected growth, to begin to grow. 

The key outlook issues for monetary policy are: 

▪ Are risks increasing or diminishing? Diminishing. 

▪ Do they require more insurance cuts? Not after October. 

▪ Will the risks will be realized and portend a still-sharper slowdown, hence justifying further cuts?  Maybe. 

▪ Will the incoming data call for additional cuts after October? Possibly. 

▪ Will growth slow to a below-trend rate next year, even without realization of those risks? Probably. ▪ Will the outlook calls for a preemptive easing in light of the zero-lower-bound (ZLB) problem? Could be. ▪ Is low inflation likely to effect monetary policy? No. 

Growth Slowing to Trend. Then What? 

The economy grew at a 2½% rate in the first half of 2019: comfortably above trend, as expected. With a  good deal of the monthly data already in hand, it appears that real GDP growth in Q3 will be in the range of  1½% to 2%. The Q3 GDP report will provide a better assessment of the degree of the slowdown. And interestingly, that report will come on the second day of the meeting. Imagine the prospect of a downside surprise in growth just as the “final” statement is being passed around the table. That might prompt a sharp increase in market expectations of a cut in December even before the statement is released and the press conference begins! Still, that data is for a single quarter, and it will be revised a couple of times in the coming months. 

Even before the effects of the tariffs implemented to date, the uncertainty about trade tensions, and the sharper-than-expected slowing in global growth, we anticipated a slowdown in U.S. growth to trend and then to below trend. However, the path of the fund’s rate (both actual and projected) is substantially lower than what was expected back then. We emphasize that this is relative to what has projected a year ago. That 

helps explain why participants’ median projections for growth and the unemployment rate (especially for  2019-2020) have been relatively stable. 

Inflation: A Non-Issue 

Inflation is a non-issue for most policymakers today because many, like us, see inflation as already firming and continue to expect 2% inflation next year. It is likely to remain a non-issue going forward. Monetary policy today is about extending the expansion. Period! To be sure, muted inflation this year provided an opportunity to ease without any concern about too-high inflation. True, some participants favored more 

aggressive easing because they believe inflation expectations have already eroded. And even if they haven’t already eroded, continued low inflation threatens an erosion. Still, we continue to see the lower 12-month  inflation rate this year as reflecting the three soft monthly prints in Q1, and this too will pass. Indeed, core  PCE prices have been rising since March at an annualized rate slightly above 2%. The weak start will likely leave inflation a few tenths below 2% at the end of this year, on a Q4/Q4 basis. Nevertheless, it will be on its way to 2% next year. 

Unemployment Rate Edging Higher: Recession Risk 

We expect the slowdown in growth in the second half and into 2020 to stabilize the unemployment rate at its current 3½% rate. The median estimate of the NAIRU has been declining. We expect it will edge down further. The NAIRU is highly uncertain. Even an unemployment rate at 3½% might not be much below it. In any case, given how flat the Phillips curve, the low unemployment rate is unlikely to affect inflation meaningfully. 

Payroll employment gains are slowing toward the threshold consistent with a constant unemployment rate:  perhaps 80-100K a month. The signal from GDP growth and job gains would be well aligned. Both bear careful monitoring. We expect a slowdown in growth in 2020 and 2021 to a rate slightly below trend. As a  result, the unemployment rate would edge up, perhaps by ¼ pp by the end of 2022. On the one hand, that wouldn’t be much to worry about, since the uptick would be modest and the unemployment rate would be moving toward the estimated NAIRU. On the other hand, it would reflect diminished momentum. This could suggest a heightened probability of the economy sliding into recession. 

No Recession 

The big issue in the forecast is the potential for a recession, given the slowing of growth already underway and the presence of asymmetric downside risks. If there is a recession, it is most likely to come by mid-2020,  triggered by those forces. Here are the considerations that lead to concerns about a recession over the horizon. 

1. There is increased vulnerability due to a possible slowdown to below-trend growth. 2. The realization of those asymmetric downside risks. 

3. There have already been some troubling developments: Manufacturing is contracting. That’s not necessarily a sign of impending recession, but nevertheless worrisome. 

4. Investment and exports have been weak. 

So why do we have a no-recession call all the way through 2022 as a baseline? 

1. We do not expect the asymmetric downside risks to be realized. 

2. One factor that has contributed to recessions in the past has been a move of monetary policy into restrictive territory. This was almost the case, but the FOMC pulled back and has been easing instead of tightening.

3. The 3-month-10-year yield curve slope was inverted for several months, but recently reverted to  positive territory. 

4. If there is no recession by mid-2020, we have no specific reason to project one further out in the forecast, though the risk is surely there. 

Soft Landing 

No recession leaves us with a soft landing as the most likely outcome. Growth at the trend in 2022,  unemployment near the NAIRU, and inflation at 2%. Macroeconomic heaven? Maybe. But 2022 is too far away to be remotely interesting. Focus on 2020. 

FOMC Call 

The Committee will vote to cut the funds rate again in October. This easing will be the third consecutive 25- basis-point cut this year. The market assigns a probability of near 90%. The probability is so high because it rose following a couple of early disappointing data releases. Then the FOMC made no effort to lean against market expectations and to buy optionality for the meeting. The FOMC’s decision would not be as obvious if the market probability were only, say, 30%. That’s what the narrative from participants during the intermeeting period has strongly suggested. Our focus is on what’s next, and we will be informed, maybe,  by the FOMC statement and Powell’s press conference. 

More Insurance Against Asymmetric Downside Risk? 

Why should the FOMC cut the funds rate again next week? The first candidate is further insurance against asymmetric downside risks. However, the risk of a further escalation in trade tensions with China seems diminished, though any agreement is likely to leave tariffs where they are, with the attendant damage already being felt. Brexit is still up in the air, with the decision being postponed again and again. The forecast already takes into account the global slowdown, though it could again turn out to be sharper than expected. So perhaps there is a weaker case for a cut in October based on risk management. After October, the case for further easing is likely to shift from risk management to the incoming data and the outlook. 

Easing to Extend the Expansion 

While the easings so far have been insurance cuts, they have turned out to be fortuitous because they have leaned against the slowing in growth already in motion. They have allowed the FOMC to maintain their macro forecast in the face of forces that otherwise would have sharpened the projected slowing. For some, persistently low inflation and fear of erosion in inflation expectations call for further easing. But inflation is firming. Inflation expectations are a bit shaky, but not definitively eroding. Going forward, further easing is more about data dependence than risk management. The market probability of a December cut at this point of about a third seems about right to us. 

Preemptive and Aggressive 

If growth slows to below trend and the unemployment rate begins to tick up, the probability of recession increases. Here the trend is definitely not your friend! In that case, when is more preemptive and aggressive easing called for? The playbook is clear: Given the limited room to cut rates, the FOMC should in that case be preemptive and aggressive to move toward the zero lower bound. Indeed, if there is a recession by mid 

2020, there is a very high probability that the fund’s rate will be at zero by the end of next year. The Message: Buying Optionality? 

We expect the message the Committee wants to send about further cuts is: “It depends.” Today, participants generally say the cuts are not intended as part of an extended easing cycle. But with each additional cut, it 

looks increasingly that way. How does the Committee convey that they really mean it this time, that there should be no presumption of further rate cuts? 

Just before the blackout period for communications began, both Clarida and Williams reiterated the intention  to “sustain the expansion” and “act as appropriate.” The FOMC and Powell will likely hew close to that philosophy. They will repeat the guidance (or lack thereof) that the path thereafter is data-dependent and will be decided on a meeting-by-meeting basis. But the statement and or the press conference must do that more effectively next week. 

The Statement 

The statement now abstains (mostly) from forwarding guidance. The principal signal comes from the first paragraph, on the information received since the last meeting and the state of the economy. Here there are two sometimes-conflicting considerations. The first is simply to “tell it like it is.” After all, it’s just about the facts. Still, the facts can be interpreted and described somewhat flexibly, allowing the Committee to present them in a way that’s consistent with the message it wants to send. 

Most of the key features of the outlook seem to point to a dovish message. Growth is slowing. Employment growth arguably is slowing. Inflation remains low. Measures of long-term inflation expectations have softened. 

Still, we do not expect a drastic change in the language, to avoid sending a message the markets may interpret as dovish. If Q3 real GDP growth comes out closer to 1% than to 2%, it might be seen as testing the limits of leaving unchanged the language that economic activity has been rising at a “moderate” pace. However,  “moderate” still seems to describe the underlying pace of growth. We doubt they’ll want to risk being interpreted as suggesting that has changed. One way to solve this, even in the case of a softer Q3 print,  would be to say that activity has been expanding at a moderate pace “so far this year.” 

There’s some uncertainty about how the FOMC will change the language on growth in various sectors. In previous statements, they’d provided characterizations of household spending (consumer spending and residential investment) and business fixed investment. In the September statement, they added a reference to weak exports. Where do things stand? Consumer spending appears to have slowed substantially in Q3, but from an outsize 4.6% pace in Q2. It’s held up pretty well. And residential investment looks like it expanded in Q3 for the first quarter since late 2017. We think at most they would downgrade household spending only slightly, perhaps from “strong” to “solid” or by noting a moderation in Q3. In our guess we have them noting  it “moderated from its strong second-quarter pace.” Business fixed investment still looks simply weak. Net exports appear to have continued to be a drag in Q3, though exports likely increased. We think they’ll say  business fixed investment and exports remain “weak,” as opposed to “weakened.” 

The labor market remains strong, and job gains have been “solid,” though arguably not as strong in recent months. The three-month average for payroll employment growth is roughly 150K. We’d thought that in the  September statement they might note that job gains have moderated relative to earlier in the expansion, a  point participants have emphasized in their public remarks. But they didn’t do that, and job gains over the last one, three, and six months look almost exactly like they did heading into the last meeting. Not only does the unemployment rate remain low, but it’s also fallen further since the last meeting. Inflation remains below 2%. The  October reading of the Michigan measure of inflation expectations is at 2.3%, where it was going into the last meeting. So no change in language is called for here either. Downgrading inflation expectations would also be a very dovish signal and difficult to fit into the narrative we think the Committee wants to present. 

The big question is how they’ll adjust the second paragraph, which they didn’t meaningfully change at their last meeting. They could again make no meaningful change, leaving it to Powell to deliver the message at his press conference that this cut likely completes the cuts based on risk management considerations. In our guess of the statement, however, we have them making a slight tweak to the language, which would be a  nod to those on the Committee who want to be clear that they aren’t envisioning this as an extended easing cycle. If they do change the language, they won’t want it to be too hawkish, so we don’t see a change to  “in light of implications of global developments…” followed by the announcement of a cut. No change in 

monitoring language. The Committee will still rationalize this cut as risk management. In our guess of the statement, we have them do this by adding a reference to previous cuts: “The Committee, after this action and previous adjustments to the stance of monetary policy, continues to believe that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective are the most likely outcomes. However, uncertainties about this outlook remain.” We think this gets to the point some FOMC participants have been making increasingly strongly in their public remarks. 

Our Guess of the Statement: 

Information received since the Federal Open Market Committee met in September July indicates that the labor market remains strong and that economic activity has been rising at a moderate rate so far this year. Job gains have been solid, on average, in recent months, and the unemployment rate declined. has remained low.  Although Household spending moderated from its strong second-quarter pace and has been rising at a strong pace, business fixed investment and exports remain weak. have weakened. 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 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 the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 1-1/2 to 1-3/4 1-3/4  to 2 percent. This action supports the Committee’s view The Committee, after this action and previous adjustments to the stance of monetary policy, continues to believe that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective are the most likely outcomes. , but However, uncertainties about this outlook remain. As the Committee contemplates the future path of the target range for the federal funds rate, it will continue to 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; and Randal K. Quarles. Voting against the action were James Bullard, who preferred at this meeting to lower the target range for the federal funds rate to 1-1/2 to 1-3/4 percent; and Esther L. George and Eric S. Rosengren, who preferred to maintain the target range at 1-3/4 percent to 2 percent. 2 percent to 2-1/4 percent

The Press Conference 

The less guidance in the statement, the greater the burden on Powell. No dots to help tell the story. The statement may not provide the message the Committee wants to send about the course of future policy.  Powell will be challenged in the Q&A to provide the message. Should have already given it in his opening remarks! If the Committee wants to buy optionality, Powell’s message must be focused on doing so. The best way to do that is to distinguish the motive for the 75 basis points in cuts, concluded at this meeting,  from what will drive decisions going forward. So again he will say that the economy is in a good place and the outlook is favorable. No basis in that case for a presumption of further cuts. The message is: “It depends.”

Balance Sheet 

We don’t expect any significant news on the balance sheet at next week’s meeting, which would be in line with the FOMC’s desire to distinguish reserve-management purchases from decisions related to the stance of monetary policy. 

Expanding reserves: On October 11, the FOMC and NY Fed announced reserve-management purchases and an extension of repo operations. 

Reserve management: The initial pace of purchases is $60 billion per month in T-bills. The announcements  expressed the intent “to maintain over time ample reserve balances at or above the level that prevailed in  early September 2019.” So this is a level adjustment in the number of reserves on the balance sheet— perhaps as much as $300 billion—to ensure a large enough buffer, consistent with the ample-reserves framework.  That threshold is a guidepost for when reserve management purchases will slow. 

Continuation of repo operations: It will take time for the expansion of reserves through outright purchases to reduce volatility in the repo market when there is a sharply higher demand for liquidity. So for some time (and certainly through month-end and year-end), repo operations will also be needed. The Committee has announced that these operations will continue at least through January. They are being offered at a larger  scale: now at least $75 billion in overnight operations on a daily basis (increasing to $120 billion over October  month-end) and twice-weekly term repos at least $35 billion each (increasing to $45 billion for October month 

end). 

When the level adjustment is completed, we expect that bill purchases will continue at a rate of $10 to $20  billion per month to account for the increase in currency demand and secular increase in the demand for reserves. 

IOER adjustment: As a result of recent actions, there is no longer the same urgency to ease IOER. The fund’s rate has been trading within its target range. Along with the September funds rate cut, the Fed lowered IOER  and ON RRP by an additional five basis points each. In other words, the gap between IOER (1.80%) and ON  RRP (1.70%) remained constant at ten basis points. The October funds rate cut should also be accompanied by a reduction in those administered rates of 25 basis points each. 

Standing repo facility: As with the current repo operations, the number of reserves added by the operations would be determined by market demand rather than directly by the Fed. However, the difficult questions associated with an SRF (such as setting the fixed-rate and limits on counterparties) remain open. An SRF  might not be finalized until 2020 now, especially as outright T-bill purchases have eased the need for an immediate SRF.

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