The Market Made Us Do It!

The FOMC will cut the funds rate target later this month. Done deal. It has no choice. The market insists. 

Of course, the interaction between the market and monetary policy is more complicated than this. The market pushes the FOMC. The FOMC pushes the market. Ultimately the FOMC gets its way, but if it changes its mind and does not communicate that well to the market, the market may force the Fed’s hand. 

But the FOMC should not want to counter market perceptions so strongly that policymakers lose the ability of the market to inform their view of the outlook. A bit like walking a tightrope, a balancing act. 

Markets are, in any case, a leading indicator of coming policy moves. They are not always right, but they are usually a step ahead. They have been pricing in expectations of several rate cuts and have been especially enthusiastic about a cut later this month. And that was the case before the FOMC said they would do so.  Market pricing at that point reflected expectations that the FOMC would ease, perhaps based on perceptions of more weakness in growth and inflation, heightened downside risks, and erosion in inflation expectations,  all considerations that are driving the July decision. 

Monetary policymakers had three choices: Remain neutral. Lean against market expectations. Reinforce them.  They chose the latter. If the FOMC seems to have no choice, it’s because they essentially told the market that they would ease in July. They gave themselves no choice. 

To be sure, the role of monetary policy communication is to align market expectations with policy intentions.  The FOMC has executed this brilliantly with respect to the July decision. 

The question the Committee faces at its July meeting is whether to retain some optionality, that is, not reinforce expectations for a September cut. The economy seems to be gaining some momentum and core inflation has arguably picked up. Global growth may be rebounding some. The case for a rate cut this month may have been slightly undermined, but only slightly. 

So what to watch at the July meeting? 25 or 50 basis points, of course. Powell has not leaned against 50,  and the markets have built-in a substantial probability of a September cut after a July move. The communication at this meeting will either reinforce that or lean against it to preserve some optionality. Once we know whether it’s 25 or 50, the next focus is on the statement for any change that suggests more of a  wait-and-see mode than readiness to ease further. And, of course, the key will be what Chair Powell says at his press conference. 

The problem for the FOMC—perhaps self-inflicted—is that a move of “only” 25 basis points could well result in some sell-off. A tightening rather than loosening of financial conditions, the opposite of what the Committee would like to see when it eases. But such a sell-off is one that the FOMC can live with, dramatically smaller than if the FOMC did not cut at all—the price of preserving optionality.

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