The Fed is about to take the unusual step of cutting interest rates to save an economic expansion, not an economy that seems set to be headed into a downward spiral.
The Federal Open Market Committee, at the end of its two-day meeting Wednesday, is widely expected to announce a quarter point rate cut, its first since it took interest rates to zero during the financial crisis in December, 2008. It is also expected to leave the door open to further rate cuts.
Some market pros expect a 50 basis point cut, but the fed funds futures market puts the probability of a quarter point cut at more than 78% and a half percent cut at around 22%, according to the CME Fed Watch Tool.
“What the Fed is doing is unprecedented. There’s no historical precedent…There’s no example that with still above trend growth and still above trend labor growth has the Fed eased in the middle of an expansion. This is a six sigma event. If there were more clear evidence that the trade war was hurting, this would only be a small departure from normal but actually the data in the last month has improved,” said Ethan Harris, head of global economic research at Bank of America Merrill Lynch.
Fed Chair Jerome Powell has made it clear the Fed would be willing to make a so-called ‘insurance’ cut, to protect the economic expansion, the longest on record as of this month. He has said the Fed is concerned about low inflation and that the U.S. economy is at risk from slowing global growth and the impacts of trade wars.
The central bank is also expected to move forward with its pre-emptive interest rate cuts. At the same time, President Donald Trump has laid on an unusual amount of public criticism of Powell and the Fed for current interest rate policy. Trump says the Fed should have easier policy and its interest rate policy has hurt the U.S. economy.
On the eve of the Fed’s decision, Trump said Tuesday the Fed should make a big interest rate cut. “I’d like to see a large cut, and I’d like to see quantitative tightening immediately stopped,” Trump said, commenting on the Fed’s efforts to reduce the bonds it is holding on its $3.85 trillion balance sheet.
“They moved in my opinion far too early and far too severely, and puts me at somewhat of a disadvantage,” the president added. Some economists expect the Fed to end the roll down of its balance sheet early, but the program was already expected to end in September.
“This is a high wire act. When it comes to communications, that is the hardest part. They want to do more, but they don’t know when and how much further they want to go,” said Diane Swonk, chief economist at Grant Thornton.
Some market pros expect the Fed to announce an early end to the roll down of securities from its balance sheet, which is now expected to end in September. Swonk said the Fed still has to decide what type of securities it wants to use to replace maturing securities on the balance sheet, meaning more short-term or long-term Treasurys.
Many strategists do not believe the Fed’s move to cut rates is a response to the president. “I think it’s complicating their lives because I think they don’t’ want to be seen as caving to the White House,” said Scott Minerd, co-founder and global CIO of Guggenheim. “At the same time, they want to cut rates and every time Trump talks about how they should be cutting rates, it makes their life more difficult.”
Minerd said the only way the Fed is reacting to Trump is indirectly in that they are hoping to fend off the ill effects of his trade war with China. The trade war has impacted mostly manufacturing data, dragging down exports and impacting inventories. Economists say so far, the consumer has been largely untouched by trade concerns and both consumer confidence and consumer spending are strong.
While many economists and strategists believe the Fed will cut rates, not everyone agrees it should in the face of stronger data—and that includes some members of the Fed. One of those, Boston Fed President Eric Rosengren said on CNBC recently that he did not see a reason to cut rates now, given the economy is strong and inflation is nearing the Fed’s 2% target.
“They’re going to get at least one dissent,” said Swonk. “I think that is healthy to have a dissent right now because I think that also asserts the independence of the Fed…The critical issue is perception versus reality. If people perceive the Fed as capitulating that hurts their credibility.”
Trump has also said the dollar is too weak and blamed the easy policies of other central banks, for weakening their currencies. The strong dollar could in fact become a worry for the Fed.
“When you look at it what the [European Central Bank] is doing and every other central bank…if you think about it in terms of the dollar and if the Fed doesn’t respond, the dollar is going to go up in value, and a strong dollar is disinflationary. If the Fed doesn’t go, it will miss its inflation target,” said Jim Caron, Morgan Stanley Investment Management portfolio manger.
Caron said he expects the Fed to trim by 50 basis points. “I know it’s…non consensus, but all I really am trying to say is keep an open mind for the fact that 50 is logical and, obviously the smart money thinks that they’re going to do 25. That’s what’s pricing in to the market,” said Caron. “If they don’t do 50 in July, they’re going to do 25 in September so by October, they’ll be at 50.”
But Stephen Stanley, chief economist at Amherst Pierpont, expects the Fed to make one quarter point rate cut and then stop.
“I think they want to keep their options open. I don’t think they want to disappoint the markets but at the same time, I don’t think they want to feed the beast anymore than they have to. I think the economy is holding up better than it was in June,” said Stanley.
Some economists believe that the Fed has limited firepower with the fed funds target range at just 2.25 to 2.50, and for that reason it should move ahead to prevent the economy from weakening. But on the other hand, there is a concern that if the Fed uses its limited ammunition now, while the economy is still strong, it would be powerless later on if the economy turns bad.
“The data don’t’ really support a move. Certainly, the data shows the economy is growing at 2.5% in the first half of the year. There’s at lest some evidence that core inflation, is after a brief dip in the first half, does seem like it’s coming back to a 2% trend,” said Stanley. “I think the inflation number doesn’t quite have the urgency we may have feared a month or two ago.”
The Fed targets inflation at 2%, and the number it follows, the core PCE deflator inflation gauge the Fed watches was at 1.6% in June.
Minerd said the Fed risks stoking bubbles in asset prices, by cutting rates in an environment where the economy is solid. However, he believes the Fed should cut interest rates and then go back to basing its decision, on its more traditional metric—the economic data.
“I would argue they should go ahead and cut rates. They should hem in the expectation for more rate cuts. I think they should say ‘we will adjust policy appropriately,'” he said. “Future policy actions will be driven based upon data dependency which is consistent with what they always did. I would definitely advertise this as an insurance rate cut. It’s clearly not supportable based upon the data. This is completely anticipatory based upon uncertainties around the trade war, slowing growth in Europe. They’re attempting to get ahead of it…They are going for broke.”