FOMC Had Different Ideas Than the Market

The minutes of the July FOMC meeting make clear that there’s a sizeable discrepancy between the market’s expectations for policy—multiple cuts priced in overcoming meetings—and what FOMC participants had in mind at the July FOMC meeting. It’s pretty clear that at the time of the last meeting FOMC participants were not firmly expecting to cut again a mere six weeks later, at the September meeting. Instead, as we had suspected, they appeared to want to maintain optionality about a September cut. The markets have not been obliging, because communications have not pushed back enough to leave the Committee that option. Given developments since then, along with the current state of market expectations, we see a 25-basis-point cut in September as virtually certain. However, we now see virtually no chance of a 50-basis-point cut. Indeed,  after the minutes, we see an even lower probability of a third cut this year. 

Just as Powell did at his press conference, the minutes framed the July cut as a “recalibration” or “mid-cycle adjustment” of policy based on a careful assessment of developments over some time—and not a knee-jerk reaction to the most recent developments. We note that there’s a difference between a mid-cycle adjustment and a cut based on risk-management considerations, though the minutes continued to emphasize the risks that have featured in recent minutes—growth abroad, further escalation of trade tensions, and a no-deal  Brexit—and risk management was one of the reasons that a cut was seen as warranted. 

So why do we still expect a cut in September? For one, the market not only expects one, but it also insists—pricing in a 100% probability. Think of what the market response would be if there is no cut in September. Indeed,  there were indications throughout the minutes that FOMC participants and staff were focused on what Fed policy actions were already priced into markets and underlying the current state of financial conditions. The baseline economic outlook was acceptable, but the financial conditions underlying it already were premised on a cut in rates in July and further cuts after that, totaling nearly 100 basis points. So the July cut preserved the favorable outlook; not cutting would have resulted in a tightening of financial conditions. For September,  we see it as a similar story. Another cut would just be keeping up with what’s already baked into markets. 

However, there’s a limit to the markets tying the hands of the Fed. The limit, however, comes only if the  Committee communicates that the 125-basis-point lower path of the funds’ rate, relative to last December’s projection, is the mid-cycle adjustment. The June dots showed that there was already sizable support at that time for cutting the fund’s rate 50 basis points by year-end. So while getting the full 50 basis points by  September probably would put them ahead of schedule relative to what they had in mind in June, we think  FOMC participants will be comfortable with that. 

Now we turn to some of the details of what the minutes revealed. 

At the July FOMC meeting, participants and Fed staff felt very good about the current state of the U.S.  economy and pretty good about the outlook as well. Participants “generally noted,” that incoming data since  the June meeting had been “largely positive and that the economy had been resilient in the face of ongoing  global developments.” GDP growth had been moderate and was expected to slow “a bit,” to near potential,  in the second half of the year. The global backdrop was a different story, however: “Participants also observed  that global economic growth had been disappointing, especially in China and the euro area, and that trade  

policy uncertainty, although waning some over the intermeeting period, remained elevated and looked likely  to persist.” 

Underlying this moderate pace of U.S. GDP growth was very different performance across sectors, and this was expected to continue. Participants noted, “the important role that household spending was currently playing in supporting the expansion,” especially the “robust pace” of consumer spending. They “judged that  household spending would likely continue to be supported by strong labor market conditions, rising incomes,  and upbeat consumer sentiment.” In contrast, “participants generally saw uncertainty surrounding trade policy  and concerns about global growth as continuing to weigh on business confidence and firms’ capital  expenditure plans.” There were some hints of improvement on this front: “Some participants observed that  trade uncertainties receded somewhat,” and “Several participants noted that, over the intermeeting period, the business sentiment seemed to improve a bit.” But the overall sense was that trade uncertainty is already  having an impact and is here to stay for the foreseeable future: “Participants generally judged that the risks  associated with trade uncertainty would remain a persistent headwind for the outlook, with several participants reporting that their business contacts were making decisions based on their view that  uncertainties around trade were not likely to dissipate anytime soon.” 

The story concerning the labor market was nothing new: It was strong, but with little sign of overheating,  and that was expected to continue. The story concerning inflation was more interesting, however. There had been some firmer core inflation readings leading up to the July FOMC meeting, and there was a sense of increased confidence that inflation would return to its objective. The minutes described a contingent that was  dissatisfied with the inflation outlook: “Some participants stressed that, even with the firming of readings for  consumer prices in recent months, both overall and core PCE price inflation rates continued to run below the  Committee’s symmetric 2 percent objective” and saw downside risks that might “further delay a sustained  return of inflation to the 2 percent objective.” But apparently, that contingent was clearly in the minority:  “Many other participants, however, saw the recent inflation data as consistent with the view that the lower  readings earlier this year were largely transitory, and noted that the trimmed mean measure of the PCE price 

inflation constructed by the Federal Reserve Bank of Dallas was running around 2 percent.” The minutes  stated, without attributing the statement to any particular number of participants, that “market-based  measures of inflation compensation and some survey measures of consumers’ inflation expectations remained  low, although they had moved up some of late.” That was followed by this sentence, which further suggests  a lack of confidence in the state of inflation expectations: “A few participants remarked that inflation  expectations appeared to be reasonably well anchored at levels consistent with the Committee’s 2 percent  inflation objective.” 

The minutes revealed a clear split in attitudes toward easing, as had been evident before the meeting. “A  couple” (two) participants preferred a cut of 50 basis points rather than 25 basis points because a bigger cut would accelerate the return of inflation to 2%. We suspect that the two participants were Evans and Kashkari. “Several” (perhaps four or five) preferred not to cut rates at all in July, citing a sufficiently strong economy, abating downside risks, and an acceptable inflation outlook. Recall that two voters (George and Rosengren) dissented. This passage reveals deeper disagreement about the decision to ease than apparent from the dissents alone. “A few” cited financial stability risk or the potential negative signaling effect of a  rate cut as additional reasons not to ease. Of course, one caveat with this headcount is that events could have already shifted policymakers’ inclinations since then. For example, Mester self-identified as having opposed the July cut. But she recently said she “could see scenarios where we move the rate down.” 

“Most” participants saw the 25-basis-point July cut as part of a “recalibration” of the stance of policy, or  “mid-cycle adjustment,” in response to the “evolution of the economic outlook over recent months.” The  FOMC seemed to want to make clear that the July cut was not seen as merely the beginning of a more extended series of cuts, perhaps in line with the market’s more pessimistic outlook. We read the following  line as also consistent with that notion: “Members generally agreed that it was important to maintain  optionality in setting the future target range for the federal funds rate and, more generally, that near-term  adjustments of the stance of monetary policy would appropriately remain dependent on the implications of  incoming information for the economic outlook.”

The members who voted for the rate cut said the July cut should be viewed “as part of an ongoing reassessment of the appropriate path” of the fund’s rate that began in late 2018. In particular, the gradual downward revisions to the projected peak of the hiking cycle, from 3.125% (December 2018 SEP) to 2.375%  (actual), provided accommodation and thus were an important component of this recalibration. 

To our slight surprise, there was no mention of progress on establishing a standing repo facility. Such a facility would be one way to alleviate the pressure from reserve scarcity as reserve balances continue to decline because of trend increases in non-reserve liabilities. The omission of any discussion suggests that the FOMC  attaches less urgency than the market to the need to cap money market rates. That suggests a delay in the implementation of such a facility if it is eventually established. 

The minutes also outlined the basis for the premature termination of balance sheet reduction, noting that a  sooner end to runoff would be simpler to communicate, have a little economic impact, and avoid the appearance of inconsistency with the fund’s rate tool. 

The minutes also described the first discussion at an FOMC meeting of changes to the Fed’s monetary policy framework. Staff also provided presentations. Discussions are clearly in their preliminary stages, but there were already some indications of what participants are considering. We’ll cover this topic in a separate commentary.

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