By the end of the day today, Federal Reserve Chairman Jerome Powell will have finished his round of pre-meeting phone calls to the Fed district presidents to hear their views on the economy and the policy outlook, and he should have a pretty good sense of whether he will face dissents at next week’s Federal Open Market Committee July 30-31 meeting.
*** Despite the reluctance of a half dozen or more Committee members going into this week, including two voters, we still think a 25bp cut next week is very certain. We would put the odds for a 50bp cut no better than the odds for no move at all. The statement itself is likely to note downside risks hang over an economy that is otherwise, well, not looking all that bad, while the “closely monitoring” language will see little if any change. But in messaging the rate cut as a front-loading of accommodative relatively low cost “insurance” against a deeper downturn and to stem a further slide in inflation expectations, we think Chairman Powell will also leave the door ajar for further rate cuts. ***
*** By “ajar,” we think Chairman Powell will seek to convey a tricky two-part message: that the July cut is likely to be the first of two cuts to “reset” policy back below neutral that might go no further, but that an even more aggressive easing cycle could still be undertaken if the probabilities rise significantly later this year for a marked economic downturn threatening a return to the Zero Lower Bound. Policy going forward will entail a reaction function more acutely driven by a meeting-to-meeting assessment of those risk probabilities. Crucially, if the downside risks do become elevated, the FOMC meeting in November, possibility September, could see a rate cut by 50bp. ***
*** This framing of the rate cut as “insurance” may be just enough to deter dissents, but at least one seems likely. On other fronts, we don’t have especially strong views on the likely size of the corresponding cut in the Interest on Excess Reserves or whether the planned end to the asset run-off in September will be brought forward to July, but we are pretty sure the FOMC will be sensitive to either “technical” move being taken as a policy signaling. That said, the IOER is likely to be cut by an equal 25bp while it would cost little to neatly align a July rate cut with an earlier end to the balance sheet run-off, even if the latter is not intended as a dovish policy signal. ***
A Prescient 2000 Policy Paper
It is a pity the speech by New York Fed President John Williams last week turned into such a messaging misfire because, if stripped of the market sensitivity to grasp for any rates clues on the eve of a pre-meeting black-out, the speech in fact neatly summarized the broad contours to how the Fed is adapting its reaction function to downside risks when in such a close proximity to the restraints of the Zero Lower Bound.
The speech, like the remarks in the television interview the same day by Vice Chairman Richard Clarida, was meant to reinforce the broader messaging of Chairman Powell’s own speech from Paris earlier in the week, stressing a call for “new ideas” in dealing with persistently low inflation in a world where the risk of hitting the ZLB is so much higher than before the crisis.
Williams tried to step into that breach noting that, with an eye on the zero lower bound constraint, policy must act “swiftly” to aggressively lower rates and to keep them “lower for longer” to maximize its firepower when facing anything but a “run of the mill” economic shock. What the market heard, naturally enough — the speech was, admittedly, somewhat clumsily timed — was a 50bp rate cut in July that the New York Fed had to “clarify” when a reporter called in for comment on the market reaction.
But the speech was in fact a shortened summary of a more detailed, seminal 2000 research paper Williams wrote with David Reifschneder, a colleague when both were on the Board research staff. The first draft of the paper was first presented at an October 1999 conference in Woodstock, Vermont, in which they first laid out “three lessons” on how monetary policy may need to be adapted if the economy is facing a deepening downturn but when it is constrained by the zero lower bound.
Namely, a potential need for an accumulative accommodation over a medium-term policy horizon would no longer be necessarily data-driven in the traditional sense (a point many Committee members may still be resisting), but rather by the rising probabilities of downside risks that could overwhelm even a healthy-looking base case economic outlook.
If the average total easing in previous downturns was as much as 500 basis points, but like now, the Fed has less than half that running room, Reifschnedier and Williams laid out the case for front loading a potential extended accommodation at the first sign of trouble. It would be intended to perhaps help ensure a shallower slowdown than would otherwise be the case — the insurance concept — and which would then be adjusted at subsequent meetings, depending on the story the data is telling.
But that ZLB restraint was the key concept and a game changer to the Fed reaction function: the inability of the Fed to cut as much as the economy may need to get back to an equilibrium interest rate and, in time, back to trend growth, meant monetary policy should and must be adapted to maximize its firepower.
If the rate cuts aiming to reset the policy rate safely back below neutral look to be enough, policy can be repositioned back to an “in either direction” neutral stance; but if the risks are truly darkening into a deeper downdraft for the economy, then rates should be lowered as quickly as possible and held lower for longer to come as close as possible to achieving the monetary easing that, in previous easing cycles, would have been accomplished more gradually but with far more rate cuts in total.
Elevated Downside Risks Since May
It is against this intellectual backdrop that the case for the rate cut next week, the first in more than ten years since the onset of the Great Recession, is being laid out. And it should be placed against the context of the earlier policy pivot last January.
Inflation that is persistently so soft relative to its projections, when the economy is slowing but still above its estimated trend potential, and lackluster wage growth when headline unemployment has been running well under the estimated longer run unemployment rate, have already been flashing warning signals across recent months that the policy rate may be too high relative to a r* now looking to be no higher than 2.5%, and perhaps even slightly lower.
Of course, it begs the question — one that is high on the list of reasons for the reluctance of many Committee members to cut, at least before this week’s consultations — that if policy is no longer data-driven as much as it is a risk-management calculation over “possible, future adverse shocks to the economy” (as a “few” participants argued at the June meeting, according to the Minutes), of where the line is being drawn on the sudden need to take out this “insurance” when, almost by definition, there is always the possibility of a downside shock.
That question may be even more central to the policy debate next week after this morning’s GDP revisions. While last year was marked down, the numbers were stronger than expected, as was inflation, suggesting that perhaps the low inflation was “transient” after all. More importantly, it might bolster the case that it would still be better to wait until the September meeting to unveil the pre-emptive initial rate cut rather than next week.
But our sense is that the twin trade shocks in May, the escalation in the trade threats against China and the surprise threat to impose tariffs on Mexico, nevertheless marked a major escalation of the downside risks to the growth outlook for a majority of the FOMC, enough to keep the argument for the easing and its timing intact. What’s more, we suspect the risk probabilities will look even more elevated in next week’s staff presentations and forecasts, especially with a hard Brexit risk looming even larger by this fall.
The policy stance, then, is all about risk probabilities, and coupled to the insurance concept to front-load an initial easing to perhaps help ensure a shallower than feared slowdown and which may also help to stabilize inflation expectations — to “recenter” inflation and inflation expectations is in fact the primary reason for several Committee members to ease rates back below neutral — we think Chairman Powell will be firmly among a Committee majority wanting to position the Fed for a potential follow through in the policy pivot first started in January.
The Cost of Insurance
One of the primary reasons for a possible dissent or two is a concern that the low cost of the pre-emptive insurance cuts may not be as low as it is being presumed in such an inertial low inflation environment.
Namely, the premium to be paid could eventually come not in higher goods and services inflation, but in higher asset inflation, by the very act of prematurely cutting rates and fueling another round of risk-on financial excesses that will only prove costly to unwind in the end, even if not as severe as the near catastrophic financial crisis in 2008 that brought on the Great Recession.
This may in fact still be the trigger to dissents, and the question across much of the markets as well as within the Committee for many of its participants is whether the Fed can or will push back against market expectations and pricing when the time inevitably comes?
We are not entirely sure how the Chairman and those making the case for a start to the insurance rate cut will address that exactly, but a crucial linchpin to the Reifschneider-Williams playbook at the ZLB is to bring the weight of market pricing into line with the Fed’s medium term rate path scenario to do much of the heavy lifting to maximize the intended impact of the limited monetary firepower.
In that sense, we suspect the Fed will not really mind the current aggressive market pricing for three or more rate cuts before year-end, betting that if the signals drawn from always noisy and incomplete date are nevertheless telling the Fed the high risk probabilities are falling, they reckon they will have plenty of time later this fall to push back against the market, if the data does not already do much of that for them.