There has been quite a bit of market speculation in the last few days over whether the Federal Open Market Committee this Wednesday will signal a pause on further rate cuts or perhaps adopt a “three and done” messaging on the policy path going forward.
A few points to preview our expectations for Wednesday’s statement and press conference:
*** First, we still think a third rate cut this year is more likely than not. It will remain a finely debated point, and the decision may come down to the optics and the background mood music of a surging stock market and data to date that has only been disappointing rather than deteriorating; if truth be told, neither making the case for a rate cut any easier. But on balance, as we noted last week (SGH 10/22/19, “Fed: October Recalibration”), we suspect Chairman Jerome Powell and the voting members of the Committee will still opt for a cautious cut to validate market pricing and to ensure continued easier but hopefully not excessive, financial conditions. ***
*** Second, the fiercer debate is probably going to be over how to message the rate cut and the policy path going forward. While it is always difficult if not dangerous to pin too much on second guessing the wordsmithing choices in drafting the formal statement, we suspect the template of the “act as appropriate” phrase will remain in some fashion, qualified in some way to indicate a higher hurdle to future cuts or tempered with the “meeting to meeting” language. Most of all, we think Chairman Powell will make it clear that any future rate cut will have far less to do with the risk management “insurance” and more a traditional reaction function based on how the incoming data alters the forecast going forward. ***
*** Third, we seriously doubt Chairman Powell will want to communicate that the FOMC is necessarily done with rate cuts in the near term. A lot can still go wrong that calls for caution, and there is probably more of a consensus across the Committee, hawks and doves alike, in prizing policy optionality, until either the data begins to tell a clearer if not brighter story or the trade and geopolitical uncertainties truly lift. Until then, we doubt the FOMC will want to limit their flexibility with strong guidance one way or another on Wednesday, and indeed, the FOMC has been striving for the better part of this year to get out of the near-term policy guidance business altogether. ***
On that point, we were reminded of what Fed Chairman Jerome Powell said at his last presser in September, perhaps in anticipation of the inevitable questions over whether the Fed would continue to ease after the two rate cuts in July and September: “I’d love to be able to articulate a simple, straightforward stopping rule, but it’s really just going to be when we think we’ve done enough,” he said in his low-key, common sensical tones. “There will come a time, I suspect, when we think we’ve done enough, but there may also come a time when the economy worsens, and we would then have to cut more aggressively. We don’t know.”
The Evolving Policy Narrative
It is interesting that a rate cut would bring rates back to a 1.50%-1.75% target range for fed funds is where rates stood in the spring of last year, when a strong economic growth well above trend estimates, a tightening labor market, and expectations of a further twin stimulus from the tax cuts and the boost to budget spending was pushing the FOMC to bring the policy rate up to or above its then estimates of neutral rate of at least 2.5%.
Unforeseen, of course, was how damaging the trade wars would be, in the uncertainty effects on both US and global business confidence and investment that, in effect, slowed growth through this year more than what would have been intended in the higher rates being penciled in by the FOMC right up through their December meeting. The policy pivot since January, culminating in the rate cuts, was meant to rapidly adjust the policy stance to reflect the falling short run r* estimates against the darkening outlook.
Critically, the binary nature of the slowing growth, with the hit to the narrower manufacturing sector spending being offset by the still resilient broader consumer spending, amid the sharp political attacks by the White House, pushed the FOMC into the 1995-style risk-management assessment of the rising risk probabilities that hung over the base case outlook for slowing but still above trend growth.
“Insurance” rate cuts to bring the policy rate back below neutral, in what Chairman Powell described in July as a “mid-cycle adjustment,” was intended to sustain the expansion, and if the later data were to prove new accommodation was unnecessary, the argument in July and again in September was that the rate cuts could be “taken back” in 2020 or 2021, depending on the appearance or speed of excesses in inflation or asset prices.
The hurdle to make the case for a third insurance cut is clearly higher, however, making the decision a closer one, and perhaps best indicated in the remarks just before the October pre-meeting black-out noting how policy operates with lags, and more time would be needed to gauge the effects of the rate cuts and overall accommodation put back into the economy all this year.
Indeed, our sense was that there had been a fairly strong sentiment across the Committee in the immediate wake of the September rate cut to pass on any future rate moves until at least the December meeting, by which time the data just may tell a clearer story on the outlook.
That ambition, however, tipped for us towards a rate cut rather than a pass in October in the early signs across some of the data that growth may be slowing a little more than forecast at the September meeting. And even amid the truce in the US trade negotiations and tariff threats with China, or the European Union, we think it will be seen as the safer, more prudent course by the voting members of the FOMC to nudge the policy rate down by another 25 basis points, and with it, to gently steer market expectations back to the changing reaction function going forward.
Acting Appropriate, Qualified
We doubt very much the “act as appropriate” language was ever intended to be so narrowly understood to be only automatically signaling rate cuts; if it did, they would never have gotten a consensus on the phrase. It was really meant to be a step away from explicit forward guidance, and in that sense, directionally neutral, in that they would be doing whatever it takes to keep the expansion going. That said, since there is absolutely no upside risk, its meaning was fairly obvious in the circumstances to date.
Those circumstances can change, of course, and with them, the meaning to the policy language phrasing. But how the Committee opts to fine tune the language, we will wait to see on Wednesday afternoon, our dictionary and thesaurus at the ready. But the main point is that Powell will not want to signal they are necessarily done on rates, either as a pause of some length or a “three and done” message; in other words, he will not want Wednesday to be taken as a “hawkish cut.”
We suspect the Fed is in fact perfectly ok with the current market pricing for October and some optionality for December, because all else being equal, they would prefer the market to maintain supportive financial conditions as opposed to the reverse of tightening conditions so much it could darken the outlook when growth is already ebbing so close to trend.
And while at some point, the Fed may have to disappoint the market, Wednesday is unlikely to mark that day of reckoning.