Policy Call Intact, Balance Sheet Expansion Sooner

Our call remains that the FOMC will cut the funds rate once more this year and that this further cut would be more likely to come in December rather than October. Today’s cut was about negative surprises since the  last meeting, both in the incoming data and concerning “global developments.” It would take more of the same to tip the scales toward another cut—but not that much more. That’s because there’s clearly a strong bias toward further easing, notwithstanding Powell’s unwillingness to comment on the topic in his press conference: While the median shows no further cuts this year, many participants project that at least one further cut will be appropriate. Given that the most recent domestic data have been pretty solid, we don’t think they’ll cut again in October, assuming there are no substantial flare-ups on other fronts such as Brexit or trade. But the FOMC is still overwhelmingly focused on sustaining the expansion, and so by the December meeting, we think there are better-than-even odds that developments either domestically or globally will lead the FOMC to cut rates once more. But that remains a very close call. 

As mentioned above, Powell clearly didn’t want to talk about conditions for further rate cuts, and we didn’t see his comments in his press conference as providing much insight as to what it would take. He came tantalizingly close when he alluded to the difference between making “modest adjustments to the federal funds rate” to maintain a positive outlook versus pursuing “a more extensive sequence of rate cuts” when there seems to be a downturn (which in current circumstances would take us to the zero lower bound). But he didn’t elaborate on how the FOMC would decide between two or three total cuts this year—both of which would fall in the first category. He again pointed to the success of the 1995 and 1998 insurance cuts, both of which totaled 75 basis points. But we still don’t think that means the FOMC must cut the same amount this time. 

Balance sheet policy has also come under focus following strains in short-term funding markets earlier this week and the New York Fed’s repo operations. As a result, the FOMC lowered both the IOER rate and ON  RRP rate by more than the reduction in the fed funds rate. Powell also suggested in his press conference that the likelihood of an earlier resumption of asset purchases has risen. But he emphasized that the FOMC  continues to see these issues as irrelevant in terms of economic impact and that they are unrelated to the  FOMC’s assessment of appropriate rate policy. 

The Statement 

The only substantive changes to the statement were in the first paragraph. The investment was downgraded: It has “weakened” (vs. “has been soft” in July). The statement added a reference to exports (also “weakened”).  In contrast, consumer spending has been “rising at a strong pace” instead of merely having “picked up from earlier in the year” (as in July). The statement continued to characterize the pace of job gains as “solid.” We’d thought the statement might also note that they had “moderated,” but there was no mention in the statement of a change in the pace. Powell did make this point in his prepared remarks, however, saying that the pace had “eased” and noting that this was something that had long been anticipated. 

The second paragraph was unchanged except for an updated reference to the new target range for the fund’s rate. The decision to cut the funds rate was again made “in light of the implications of global developments  

for the economic outlook as well as muted inflation pressures.” That seems slightly outdated, since, as both the first paragraph and Powell in his press conference noted, some parts of the domestic data have been soft,  particularly those related to manufacturing, exports, and investment. In explaining the decision to cut rates  in his prepared remarks for his press conference, he said, “we’ve seen additional signs of weakness abroad  and resurgence of policy tensions including the imposition of additional tariffs.” 

The second paragraph also included the same guidance that, “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.” Some market participants have seen that as signaling an easing bias for the next meeting. But we don’t see it that way. True, the FOMC used that language in July, then eased again in September—but developments since July warranted a September cut.  That won’t necessarily be the case at the next meeting. 

George and Rosengren dissented because they preferred to leave the fund’s rate target unchanged at this meeting. The dots suggest that three other participants agreed with them. Bullard also dissented, but dovish.  He advocated a 50-basis-point cut at this meeting. This is the first time Powell has faced three dissents. 

The Outlook 

The projections for real GDP growth, on the one hand, show a steady decline of a tenth each year from the current pace of 2% in the second half of this year and 2020; growth goes from the above trend in 2019 to below trend by 2022. But that is not really the story here at all. Rather, a better characterization is that they see the economy growing at about trend in 2020 through 2022, indicative of a soft landing. In this case, the  FOMC lowered rates enough this year to sustain growth slightly above the trend this year and to support growth at trend into 2020 and 2021. Then, with great foresight, they project 25-basis-point hikes in 2021 and 2022,  to prevent the economy from overheating! If that’s not fine-tuning, I don’t know what it is. Consistent with the soft landing story, core inflation moves from 1.8% to 2% by 2021 and remains there in 2022. Completing the story of virtually perfect policy, the unemployment rate rises a tenth in 2021 and 2022—back closer to,  but perhaps still slightly below, the estimated NAIRU, which was unchanged at 4.2%. So, the forecast is that we end up with what is virtually macro heaven for a central banker: trend growth, inflation at its objective,  unemployment rate near the NAIRU, and a funds rate at r-star. Given that they condition their projections on appropriate monetary policy, it is not surprising that they end up in a soft landing. And we are with them— our forecast is also for a soft landing! Of course, we will both be wrong, but let’s hope for the best.

Projections of inflation and growth in the real gross domestic product (GDP) are for periods from the fourth quarter of the previous year to the fourth quarter of the year indicated. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated.

The Dots 

The median dots for 2019 were for two cuts; that is, no third one later in the year. The distribution showed that five participants did not believe that even a second cut was appropriate. The median dots also showed no further rate cuts in 2020. The surprise was that the median dots suggested that it would be appropriate to raise the fund’s rate 25 basis points in both 2021 and 2022 to promote a soft landing. While this was a surprise, there is a consistency to the projections. Participants expect that growth will be at potential, inflation will be at its 2% objective, and the unemployment rate will be close to the NAIRU. We often refer to that as macro heaven. In that case, the fund’s rate should be at its neutral level. 

Another way of thinking about this is that the July and September cuts were insurance cuts in light of asymmetric downside risks. Participants appear to believe those asymmetric risks will not be realized, so the insurance cuts should be taken back. 

In any case, 2021 and 2022 are too far out to be taken too seriously in terms of the course of monetary policy. We continue to see the third cut this year (December) as a close call. 

It wasn’t just the median dots that surprised; the full distribution of policymakers’ dots was also surprisingly hawkish. For 2019, there were five policymakers above the median, which strongly suggests that, in addition to the two hawkish dissenters, George and Rosengren, there were three other policymakers who did not want a rate cut today. The other dissent, Bullard’s, was dovish, but he did not seem to project any additional cuts beyond the 75 basis points of cumulative easing he wanted by this meeting. 

Seven dots were below the median in 2019, all of which projected only one more cut (a third cut). No one projected the fourth cut. 

The 2020 median projected no more cuts. If one assumes that the ranking of the dots by the participant is preserved, then three participants project a hike, and one projects a cut. The 2021 and 2022 medians indicated one hike in each year. 

The median longer-run funds rate also stayed steady at 2.5%. But the distribution shifted down. One participant (not Bullard) projected nominal r-star to be 2.0%.

Balance Sheet Issues: “Organic Growth” of Balance Sheet As Soon as October 

Following the surge in overnight lending rates earlier in the week, we saw the Fed as likely to lower the IOER  rate by 30 basis points (instead of 25 basis points) to exert downward pressure on the fund’s rate, and they did. 

In addition to the IOER adjustment, the FOMC also lowered the ON RRP rate to 1.70% (from 2.00%), the first time that the ON RRP rate is being set below the lower bound on the fund’s rate target range. The gap between ON RRP and IOER was prevented from narrowing as a result of the IOER adjustment. 

Powell’s prepared remarks emphasized that the Fed will continue to monitor market developments and  “conduct operations as necessary” to foster trading in the federal funds market at rates “within the target  range.” Note that this comment, like the New York Fed’s announcements of repo operations this week, is a  departure from the “well within” standard (within 5 basis points of the upper bound) previously sought by the FOMC. 

Powell also assured the market that policymakers will, “over time,” provide a sufficient supply of reserves  “so that frequent operations are not required.” This was a reference to the long-planned resumption of  Treasury purchases when necessary to ensure that reserves remain sufficiently abundant. The Fed now realizes that reserves do not have much further room (if any) to decline, at which point growth in reserves will be accomplished by expanding the SOMA portfolio via purchases of Treasury securities. 

The urgency of resuming asset purchases is apparent. Powell said, “We may need to resume the organic growth of the balance sheet earlier than we thought. That’s always been a possibility and certainly  is now.” In addition, not only did Powell say that this would be considered at the next FOMC meeting, but he also indicated that progress will be made during the intermeeting period. This was intended to reassure the market that the Fed is not complacent about this issue. The need for liquidity injections over the next few weeks (particularly around quarter-end) would dictate the number of asset purchases needed. The likely timing  of the asset-purchase announcement now seems to be the October 2019 FOMC meeting: “we’ll be looking  at [funding pressures] carefully in coming days and… take it up at the next meeting.” That timing coincides with one scenario already presented in the NY Fed’s updated balance sheet projections, in which asset purchases resume in 2019:Q4. 

Powell also argued that tightness in short-term funding markets has “no implications for the economy or the stance of monetary policy”—so the fund’s rate path will be determined solely by economic fundamentals rather than by liquidity concerns. He reiterated that “ample reserves” remained the FOMC’s regime. He cited tax schedules and private Treasury holdings as sources of the recent pressures. He acknowledged that money market strains were more serious than policymakers had anticipated. He expressed faith that the repo operations on Tuesday and Wednesday would suffice to move the fund’s rate back into its target range. In his  view, the repo operations were “effective in relieving funding pressures.” But tightness remained even after those operations, and the Wednesday operation was not large enough to satisfy demand. 

Late on Wednesday afternoon, the NY Fed announced a repo operation on a third consecutive day. The parameters of the operation were similar to those of the operations in the previous two days (except with a  lower bid rate to reflect the rate cut). Notably, the NY Fed opted to keep the total size of the program capped at $75 billion despite the operation on Wednesday having been oversubscribed. 

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