July…Probably

While we expect two cuts this year—the first in July—we nevertheless see the high probabilities assigned by markets to near-term rate cuts as too aggressive. 

▪ The market is pricing in a chance of a June cut, a high probability of a July cut, and 50 basis points in cuts by September. 

▪ This suggests that if the language in the statement pushes back too strongly against a July cut, there could be an outsize reaction. 

▪ We think that there is zero chance of a move in June and that July is a closer call, though it remains our  baseline call. 

The economy is in a good place, but… 

▪ Policymakers’ mantra has been and continues to be, “The economy is in a good place.” And it certainly  is. 

▪ The “but” refers to what follows, a list of downside risks and an assurance that the Committee will do what’s appropriate to sustain the expansion. Read that as ease when appropriate, a clear bias toward the next move being an easing. 

What would be possible triggers for a July cut? 

▪ Evidence of an earlier and faster slowdown than expected. 

▪ Confirmation of a turn in the labor market. One data point is not enough. 

▪ Escalation of downside risks, for example, coming out of the G-20 meeting. 

▪ A sharp decline in equities in the intermeeting period. Yes, that’s a good predictor of an easing at the  next meeting. 

▪ A further decline in measures of long-term inflation expectations. 

Indeed, while it hasn’t gotten the most attention, one of the most worrisome developments since the last time the FOMC updated their projections, in March, is a further and material decline in measures of longer-term inflation expectations. 

▪ The slide in longer-term inflation expectations is more important for near-term policy than the low readings on core inflation. 

▪ But low longer-term inflation expectations are a consequence of the persistent undershooting of the 2%  objective. 

▪ This decline, more evident after we moved our call to July, is an important reason we are staying there. 

The first easing is nevertheless likely to be principally about risk management. That’s what the message has been from Powell and Clarida. 

▪ Clearly, risks to growth are asymmetric to the downside, though the Committee is not yet prepared to use those words. 

▪ In our pre-FOMC calls this round, virtually everyone wanted to talk about the G20 meeting. ▪ Should there not be promising signs coming out of the G20, perhaps from a meeting between Xi and  Trump, the stage could be set for a further escalation in downside risks. 

The focus should be on language—in the statement and at the press conference. 

▪ The rate decision has already been made, but the statement language remains up in the air during the week before the meeting. 

▪ Will the statement drop the “patient” language? This is the most important decision. The markets strongly think so. We expect so. 

▪ We expect the “patient” language to be replaced by language like Powell has used: In effect, the  Committee is monitoring developments and will adjust policy (read “ease”) as appropriate. ▪ Will there be a return to a balance-of-risk assessment? Probably not a full return, with an explicit assessment of the balance of risks. But we think there could be a mention of the role of the “balance of risks” as a factor relevant to doing what’s appropriate. 

▪ Powell will try to walk a fine line at his press conference. He’ll want to leave the door open to easing while stressing that a cut is not a foregone conclusion. 

And then there are the dots! 

▪ We expect a few dots to a show one cut this year, but not nearly enough for the median 2019 dot to  show a cut. 

▪ We expect that the median dot implying a hike in 2020 will finally be gone.

Outlook Context  

The keys to the outlook are whether there is evidence of a sharper and earlier slowing in growth than FOMC  participants have expected and whether the weak job growth in May is confirmed in the next employment report. And, of course, developments with respect to trade have the potential to weigh on sentiment and move markets. While there are asymmetric downside risks for core inflation relative to the 2% objective, more worrisome at this point would be a further slide in measures of longer-term inflation expectations.  

A Brief Recap of Recent Developments  

A couple of weeks ago we moved up our expected timing of the first-rate cut from early 2020 to September  2019. A soft turn in the spending data had pointed to a sharper-than-expected slowdown in real GDP growth in Q2. Global growth looked weaker, and an escalation in China-U.S. trade tensions seemed to represent a  real worsening in the prospects for a near-term resolution. All those developments were accompanied by a  deterioration in financial conditions, including a sharp decline in equity prices, Treasury yields, and breakeven inflation rates. The core inflation data had continued to come in soft. After all of these developments, we  expected that, by September, the argument would prevail that, after a long period of patience, a 25-basis 

point rate cut would represent a prudent recalibration of monetary policy.  

Shortly after we moved up our rate-cut call to September, intense speculation began about the prospects for a near-term funds rate cut, partly related to Trump’s announcement that he would impose tariffs on imported goods from Mexico. The resolution of the Mexican tariff issue and the expectations for Fed easing coincided with a rally in U.S. equity prices. Then came the very disappointing employment report for May, which led us to move up our rate-cut call to July. Earlier last week we also had another soft report on core inflation. On  Friday, we had a better-than-expected retail sales report, as well as soft data on consumer sentiment and inflation expectations from the Michigan survey. Crosscurrents, as the Chair likes to say.  

The Employment Report: An Outlier or a Signal? 

The meager 75K increase in payroll employment in May (which was completely offset by downward revisions to the previous two months) was indeed a surprise, though we had a warning earlier in the week from ADP.  But while this report represented a substantial disappointment relative to expectations, it’s important to remember that it still painted a picture of a healthy labor market in absolute terms. The unemployment rate was unchanged in May at 3.6%, an almost 50-year low. Payroll gains have averaged about 150K over the last three months—not bad at all.  

First Half Growth: Slower, but Solid  

Previously we saw the incoming data as suggesting a slowdown in Q2 growth to closer to 1% than 2%,  pointing to an earlier and sharper slowdown in growth than we had anticipated. The more recent data,  concluding with Friday’s retail sales report, now suggest a reading closer to 2%, leaving first-half real GDP  growth near 2½%, what we expected at the beginning of the year. And equities are back up near their highs.  On balance, momentum in economic activity looks a bit weaker than anticipated, but not all that much. No need for a drastic change in the baseline growth forecast, especially if FOMC participants change their policy assumptions. The bigger change may have been to the risks around the baseline forecast.  

Perhaps Transient, but Low Inflation is a “Reality”  

Vice-Chair Clarida had a telling comment on the very soft 12-month core PCE inflation rate: “We think some of that, a lot of that, maybe transitory. But the reality is that it has been softer” (italics our emphasis).  Doesn’t sound like much conviction that we will soon get to 2% (or very near) on a sustainable basis.  

While 12-month core PCE inflation is running near 1½%, the Committee is also monitoring the Dallas Fed trimmed mean and related measures that still seem anchored at 2%. But that just means that there are components of the inflation data that again and again are restraining overall inflation. Very different from the

the one-month sharp decline in the price of wireless communication in March 2017. In any case, we agree with  Clarida’s sentiment.  

Are Inflation Expectations Eroding?  

They appear to be. The five-year five-year forward breakeven inflation rate has fallen about 15 basis points since the May FOMC meeting, back toward the lows reached early this year. The Fed staff’s decomposition of that rate attributes only about a third of the decline since early May to lower inflation expectations, with most of the rest attributed to a more negative inflation risk premium. It’s not clear policymakers will take  much solace in that, since, in the Fed staff’s own words, a decline in inflation risk premiums is associated  with investor concerns about “outcomes where lower inflation is associated with lower growth.”  

The preliminary June print of the measure of longer-term inflation expectations in the Michigan survey was  2.2%, a historic low for this series, more than reversing a surprising rise in the previous report. The New York  Fed survey measure is telling a similar story, a continuing and material weakening of inflation expectations.  Policymakers are very concerned if they see inflation expectations moving toward actual inflation, rather than the other way around. That makes it much harder to raise inflation back to 2%, and it’s very hard to even without that!  

The Dots: Even Flatter  

We expect a small number of dots implying a cut in rates in 2019, but not enough to put the median there.  Still, the more dots implying a rate cut this year, the greater the reinforcement of expectations of an early  (July) cut. We expect the median dot implying a rate increase in 2020 to finally disappear, leaving a flat funds rate path. However, it wouldn’t shock us if the median dots still showed a hike in 2021, especially if the longer-run dots don’t move down much.  

Macro Projections through 2021  

In March, FOMC participants were projecting growth close to trend, starting a bit above in 2019, then edging gradually lower. Momentum now looks a little weaker. But we also expect participants to mark down their dots. That suggests there will be little change in the median projection for growth.  

Little change in the growth projections implies little change in the unemployment rate projections, all else equal. But the unemployment rate has declined more than expected since the FOMC met in March, so the median projection for the unemployment rate at this week’s meeting should be re-leveled down.  

The March median projection for core PCE inflation was 2% in each year through 2021. That is too optimistic.  We expect they could mark down core PCE inflation in 2019 by two tenths to 1.8%, which would still be optimistic. Of course, the data made them do it. It made us move to 1.7%. It would be more telling if participants revised down the median projection for 2020 core inflation. It’s too soon to mark up projected core inflation for any effect of tariffs, which, in any case, would be small and something the Committee would look through. That will change if additional tariffs are imposed on China.  

The Stars  

The fund’s rate in the longer run (the nominal neutral fund’s rate) has been falling or at least now edging downward. We have been expecting the longer-run dots to keep edging down and think the median could move a couple of tenths slower, to 2.5%, over the next several meetings, especially if the economy comes in weaker than expected. It wouldn’t take very much—only two dots moving to 2.5%—for the median to edge down to 2.625% in the June SEP. There’s a good chance of that since we expect many FOMC participants to be revisiting their dots and marking down the projected pace of rate hikes through 2021.  

We think it is more likely than not that there will be a further downward revision to the unemployment rate in the long run (the NAIRU), continuing that trend. We have argued that downward surprises in inflation often

result in downward revisions to the NAIRU. Since March, we’ve had downward surprises in both core inflation and the unemployment rate.  

We don’t anticipate any change in the growth rate in the long run (potential output or trend growth).  FOMC Call  

We recently moved our first-rate cut forward from September to July and moved the second from 2020 into late 2019. While the employment report encouraged us to move the cuts earlier, we have had our call for two easings, the first in September, for some time. That call reflected our expectation that softer incoming spending data pointing to slower growth, a perception of more-asymmetric risks to the downside, and continued muted inflation would lead FOMC participants to judge that a slightly lower funds rate target was more appropriate.  

But growth appears not to have slowed as much as we expected in the first half, and the intensity of downside risks don’t yet point to such an early move. While we see it as a closer call than the markets, we are staying in July.  

Guidance from Vice Chair Clarida  

In a Q&A on May 30, Vice Chair Clarida said this: “The economy is in a good place…However, let me be very clear that we’re attuned to potential risks to the outlook. And if we saw a downside risk to the outlook, then that would be a factor that could call for a more accommodative policy. And so that’s definitely something in the risk management area that we would think about” (italics our emphasis).  

Very revealing.  

He says, “if we saw a downside risk…” But asymmetric downside risks are what FOMC participants, and the market, are talking about. Instead of doing “what’s appropriate,” there is now a bias toward an easing. It’s about risk management.  

June? Not a chance  

As Clarida says, “The economy is in a good place.” And it is, considering the rate of real GDP growth over recent quarters and the fact that the unemployment rate is at its lowest level in nearly 50 years. The labor market remains solid, notwithstanding the disappointing May employment report. Only one participant has already called for an easing, and conditionally at that. Markets have assigned some probability to a cut in  June—not that much, but still too much.  

Let’s Count the Reasons for a July Cut  

What we said about market expectations being too high for a cut in June applies for July as well (near 70%).  Why? Many of the drivers of a July cut are already evident, but some are not.  

First, additional data confirms the slowdown and suggests it is coming faster and sharper than earlier thought, including another weak employment report for June.  

Second, and perhaps as important, a July move would be a classic case of risk management, where policymakers are looking forward with mounting concern and making a policy decision based on asymmetric downside risks. The outcome of the G20 meeting could be particularly relevant in this regard.  

Third, muted inflation. It’s really worse than that, with 12-month core PCE inflation well below the 2%  objective, at about 1½%, and likely to remain there for some time. But the low inflation is only permissive of an easing, not a primary factor pushing toward easing, given the expectation that much of it is temporary.  But it gives the Committee an opportunity to proceed with risk management, knowing the cost of moving prematurely is likely to be small, at worst.

Fourth, measures of longer-run inflation expectations are low enough to suggest some erosion in long-term inflation expectations, and both the market-based and survey figures tell us that inflation expectations may be continuing to edge lower. We just have to look at Japan, and now the Euro area, to see the danger of inflation expectations converging toward persistently low inflation.  

Fifth, the zero nominal bound (ZNB). We have said that the Committee may have adjusted what it sees as an appropriate rate policy in light of the ZNB. The proximity of the ZNB means that the danger of being too cautious can be large, while muted inflation combined with ZNB concerns suggests the FOMC really cannot ease too soon or too much in the case of a threat to the expansion. It’s not about inflation, it’s about the expansion.  

Sixth, the markets. Perceived downside risks, the incoming data, and low inflation have led the markets to put about a 70% probability on a July move. If the FOMC does not lean against this in their language in the statement and subsequent communications by participants, the market may force a rate cut. Yes, market pricing matters. It’s the responsibility of the FOMC in its communications to align market expectations with policy intentions. Can be ugly otherwise.  

The Case for a First Cut in September Rather than in July  

July is a close enough call at this point, and many of our clients think that is too soon, so we think it is useful to lay out the case for why the first cut may not come until September.  

First, going in July might suggest more urgency than the Committee actually feels at this point.  

Second, the Committee might be reluctant to make such an early move at a meeting without updated macro and rate projections. Participants stress that all meetings are “live.” But meetings with updated projections,  in our view, remain more “live” than the others!  

Third, a change in direction may require more conviction than a further move in the same direction.  

Fourth, the Committee has provided guidance that the end of September will mark the end of the shrinking of the balance sheet. Do they want to continue passively tightening when they cut rates, or do they want to move up the September endpoint that they have just announced?  

Fifth, the Committee will have not only the important advance GDP report for Q2 but also some sense of how  Q3 is shaping up. And it will have two more employment reports.  

The Statement: What a Headache!  

We see here again the danger of including forceful forward guidance—like “patient”—in the statement.  Removing it is then itself forward guidance. Doing so at this meeting would reinforce the already-high probability of a July cut the market is pricing in, a development the Committee likely would prefer to avoid.  But continuing to say they remain patient, while clearly seeing asymmetric downside risks and conveying a  sense of a bias to a rate cut, might be awkward. Might the Committee be influenced by the fact markets are strongly expecting that language will disappear, meaning taking it out would precipitate a selloff when the statement is released before Powell has a chance to provide color at his press conference? Both options present problems. In our guess of the statement, we have them removing “patient.”  

Conspicuously missing from recent statements has been an explicit balance of risk assessment. A return at this meeting would be a forceful signal. Leaving it out seems awkward given that participants—and especially the Chair and Vice-Chair—have repeated again and again the “list” and a sense of clear asymmetric downside risks to growth. In our guess, we have the FOMC opting for a softer message by including the balance of risks as consideration for policy in the sentence about the Committee being prepared to act as appropriate.  

The first paragraph on the assessment of the state of the economy in light of the incoming data is also forward guidance. In May, shortly after the first estimate of Q1 real GDP was published, they described growth in

economic activity as “solid.” The incoming data since then have pointed to weaker real GDP growth in Q2,  although the strong retail sales report on Friday raised estimates to something like 2%. Some recognition of these developments in the first sentence seems in order. They could say that the growth of economic activity has “moderated” from its solid pace in the first quarter. (Before Friday retail sales, “slowed” might have been  more appropriate.)  

In May, the FOMC noted that household spending and business fixed investment “slowed in the first quarter.”  They will likely point to continued weak business fixed investment. However, there have been strong gains in retail sales from March through May. We think the statement could say household spending “picked up”  or “firmed” in recent months, with or without a reference to a slowdown earlier in the year.  

While the May jobs report was a big disappointment, we have stressed that it still shows a strong labor market. In the first sentence, we think that the FOMC will continue to say that “the labor market remains  strong.” We think the statement will note that jobs gains “slowed” in May but continue to say that they have  been “solid, on average, in recent months.” A three-month average near 150K is certainly still solid. The statement will also note that the unemployment rate declined.  

As for inflation, there’s no need for much change, except perhaps to remove the reference to a decline. They  will continue to say that both core and headline inflation are running “below 2%.” On the other hand, it’s very unclear what the language in the last sentence on inflation expectations is likely to be. There have been important developments in both market-based measures of inflation compensation and survey-based measures of longer-term inflation expectations in recent months. The FOMC could get away with not changing the language on either one of these areas, but it seems unlikely to make no change to either. Breakeven inflation rates have fallen significantly since the last FOMC meeting. And, according to the Fed staff’s own estimates,  which they recently began publishing online, this is not just a story about liquidity premiums. However, this  is not language that the FOMC regularly tweaks, and even after the recent decline breakeven inflation rates  haven’t declined below their early-January lows, so the FOMC could get away with the same language that  “market-based measures of inflation compensation have remained low in recent months.” As for survey-based measures of inflation expectations, the Michigan survey measure fell sharply in June, from 2.6% to 2.2%.  This measure has bounced around a good bit recently, and that was just a preliminary print, so they might not be inclined to adjust the language on that basis alone. But that reading of 2.2% is an all-time low. And the New York Fed survey three-year-ahead measure, after being quite stable at 3% for much of 2018, has been moving down fairly steadily in recent months and is now at 2.6%. They don’t change the language on survey-based inflation expectations very often, but this might be enough to warrant an adjustment.  

Our guess of the June FOMC statement:  

Information received since the Federal Open Market Committee met in May March indicates that the labor market remains strong but that growth in economic activity moderated from its solid rate in the first quarter and that economic activity rose at a solid rate. Job gains slowed in May, but have been solid, on average, in recent months, and the unemployment rate declined has remained low. Growth of household spending and business fixed investment slowed in the first quarter. Recent indicators point to somewhat firmer household spending in recent months but suggest that business fixed investment has continued to grow at a slower pace so far this year. On a 12-month basis, overall inflation and inflation for items other than food and energy continued to run have declined and are running below 2 percent. On balance, market-based measures of inflation compensation have remained low in recent months, while some survey-based measures of longer-term inflation expectations have edged down are little changed.  

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. 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. 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. In light of global economic and financial developments and muted inflation pressures, the  Committee will be patient as it determines what future adjustments to the target range for the federal funds

rate may be The Committee is closely monitoring developments affecting the U.S. economic outlook as well as the balance of risks and will act as appropriate to support these outcomes.  

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 FOMC 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.  

Other Considerations: Dissents, Balance Sheet  

We don’t expect any dissents at this week’s meeting. Sure, there will be those ready to ease now, and this will be reflected in the dots. But given that the FOMC will certainly discuss the possibility of easing in the near term, we don’t think anyone will feel the need to dissent. Doing so would send a signal that that person felt the FOMC wasn’t sufficiently open to the possibility of easing, which in turn could provoke a strong market reaction. Should there be a dissent, Bullard is the obvious candidate since he has already suggested that an easing might soon be warranted.  

We don’t expect any news on the balance sheet. In particular, we want to emphasize that, assuming the  FOMC isn’t cutting the funds rate, we don’t expect the FOMC to end balance sheet runoff early as an easing measure. That would be totally at odds with the FOMC’s recent official guidance that the funds rate is its primary tool for adjusting the stance of monetary policy.

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