The July meeting is not far behind us and the September meeting is not that far away. In our last change in our call, we retained our expectation of two 25 basis point cuts this year, but moved the second to September, from “later in the year.” We also increased the likelihood of a third cut this year. Here we focus on the September decision, starting with the scorecard Chair Powell presented at his last press conference to explain why the FOMC cut the fund’s rate target in July. Then we consider developments since that meeting, including significant market developments, to update our assessment of the September rate decision, in particular, whether the FOMC is likely to cut the federal funds target rate by 25 or 50 basis points. We continue to expect a 25-basis-point cut in September, with only a small chance of 50 basis points.
Powell’s explanation of why the FOMC eased in July—which he repeated nearly a dozen times—provides some guidance about prospects for the September decision. He cited three reasons:
▪ Continuing risk management concerns
▪ Effects on aggregate demand from some of those risks already being realized
▪ Low inflation
What hasn’t changed?
The underlying question here is: Are we still in a good place? Note that this question pertains to initial conditions concerning the labor market and growth relative to trend, but not to inflation and inflation expectations.
▪ Very low unemployment rate, solid employment growth, and growth above trend, on the positive side.
▪ No incoming data on aggregate demand or employment would change our view of the outlook for monetary policy.
▪ Low inflation and concern about possible erosion in inflation expectations, on the negative side. ▪ Risks associated with the trade war, a hard Brexit, and weaker growth abroad. ▪ Consequences of greater uncertainty for business investment.
▪ Assessing how trade tensions have changed is complicated by the fact that Trump first signaled he would put 10% tariffs beginning September 1 on a range of Chinese goods imports totaling $300 billion but then made some adjustments, primarily delaying about half of the tariffs until mid-December. The U.S.
Treasury also took the step of labeling China a currency manipulator. If anything, the risk of continued and even escalated trade tensions has become more serious. China responded promptly by saying it would cease importing U.S. agricultural products, and it has already promised to retaliate in response to any further move by the U.S.
▪ The most notable response to these developments has been in financial markets. Equity prices are down, moving along a bumpy path depending on who said or did what last. Still, U.S. equity prices are close to levels at the time of the June meeting, the last time FOMC members updated their macro and rate projections. Longer-term Treasury yields, on the other hand, have plummeted.
▪ Britain seems closer to a no-deal Brexit with their new leadership. So perhaps this risk has increased; in any case, it has gotten closer.
▪ The incoming data on the global economic outlook has worsened, with German real GDP declining slightly in the second quarter and more concern about China.
▪ An increase in market pricing of at least a 25-basis-point cut in September—to 100%. So the market again insists on action.
▪ An increase in market pricing of a 50-basis-point cut in September to around 20%.
▪ An increase in perceived recession risks, principally as a result of the further decline in the 10-year yield that has increased the inversion of the yield curve based on the 10-year-three-month slope, which is considered a good predictor of recessions using probit models. There was also a (very short-lived) inversion based on the 10-2 slope, the first since 2007. On the other hand, there has been no talk about a higher risk of recession inside the FOMC.
▪ Based on our probit model, the risk of recession over the next year has increased to near a level that has preceded recessions in the past.
Why 25 basis points in September?
Coming out of the July meeting, we expected a cut in September, but we didn’t see as high a probability as was priced into the market. We took notice of at least five participants who thought the economy was still in a good place and hence did not warrant more accommodation. But the new developments have increased the probability we assign to at least a 25-basis-point cut in September.
▪ Risk management concerns have not abated, perhaps even increased.
▪ 25 basis points alone—the July cut—provides little insurance against a realization of the risks.
▪ Most believe at least 50 basis points of cumulative easing is called for this year, so it makes good sense to do so earlier rather than later.
▪ The markets insist. We noted the key to communication at and after the July meeting was to buy some optionality, so the Committee was not pushed by the markets to cut again in September if it didn’t think that was warranted. We saw the July meeting as a start in this direction, and we expected further data and communication would provide that optionality. This did not happen.
Why not 50 basis points in September?
Well, we have not said it would not be 50. Rather, we have said that a cut is more likely than not. And we’ve seen 25 as more likely than 50. Could still be 50.
▪ Given that there were several who opposed the July cut, it might be hard to marshal enough support within the Committee for a 50-basis-point cut.
▪ The incoming U.S. data have been pretty solid—led by a sharper-than-expected increased rise in August retail sales which has raised current quarter (Q3) real GDP tracking to above 2%.
▪ It might be acceptable to disappoint the market by delivering a smaller cut than the market expects, but the market impact would be much larger if the FOMC did not cut rates at all when the only question in the markets is 25 or 50.
The case for 50 in September
▪ Given concerns outside the Fed about recession risk—which may now resonate inside the Fed—risk management requires an early and aggressive response to that risk, especially given the zero nominal bound, as Clarida and Williams have recently emphasized. 50 basis points would deliver that.
▪ It would make it more likely that the FOMC could get the markets off their back. That is, it would make it more credible to communicate optionality after a 50-basis-point move, and pause until December to consider whether another cut is appropriate.
▪ It might relieve, to a degree, growing anxiety about rising recession risks, lowering short-term rates more relative to long-term rates, and reducing or even removing the recent inversion.
The data surprise, risks become realizations, new risks emerge, and forecasts change—always. So we never use the word “confident” when talking about our forecast or the associated projected rate path. So stay tuned.