Fed: Caution and Credibility

Published on June 17, 2019

Federal Reserve Chairman Jerome Powell has had more than his share of communications struggles over the last year or more, but with such an unprecedented degree of uncertainty hanging over the economic outlook, amid elevated downside risks that may never materialize, a still confounding inflation dynamic, and a less than clear reaction function, his press conference after this Wednesday’s Federal Open Market Committee meeting promises to be his most challenging to date.

*** We highly doubt the statement will deliver a rate cut on Wednesday and our base case remains a messaging repositioning to an easing bias and a possible rate cut. We never garnered much sense before the meeting blackout period of a Committee consensus yet taking shape for a rate cut without a marked deterioration in the outlook. On balance, then, we think Chairman Powell will try to steer clear of telegraphing a certain rate cut probability for July, and while it will be put on the table — and he has certainly surprised to the dovish side since December — the higher risk is disappointing a market agitating for aggressively dovish rate signals. ***

*** We expect the statement’s “patience” language to be jettisoned for the “closely monitoring” phrasing, perhaps with an explicit reference to trade uncertainties elevating downside risks; growth may not necessarily be marked down this year but in 2020, due to the trade uncertainty effects; there is likely to be a further flatlining of the 2019 median rate dots, a flattening across the three year rate trajectory, and another downshift in the median neutral estimate. There may be at least one or more lower rates projected for the first time, but we doubt a lower median. It seems equally unlikely the balance sheet will enter into the messaging mix on Wednesday though it cannot be entirely discounted. ***

*** Despite the market July pricing and the FOMC’s likely willingness to open that door, unless softening data forces their hand, we suspect the Committee majority still prefers a longer runway to a possible rate cut, which points to September over July. Most of the FOMC still wants to gauge the data on whether downside risks are dragging growth and inflation below the forecast, or for that matter, if those risks are materializing at all. Indeed, it seems likely the on/off again trade tariff threats will inject an unusual degree of tactical calculations into the June decision and that, we think, will tilt the FOMC to a near messaging caution against a rate cut that still feels premature rather than pre-emptive, and to protecting longer term Fed policy credibility. ***

A Wide Variance of Policy Outcomes

For all that we think about the base case outcome to the FOMC’s policy debate this week, it has to be acknowledged just how unusually wide the variance is in the policy decision and messaging that could emerge in this week’s meeting.

As we noted in an earlier report (SGH 5/22/19, “Fed: Steering Clear”), we understand there will be significantly wide confidence bands around the June median SEP forecasts, primarily due to the unprecedented uncertainties surrounding US trade policies and US-China relations, the geopolitical confrontations in the Mideast and the risks to crude oil supplies, and the overhang of polarized politics, be it in the US or in the Brexit-wracked UK and across the European Union. 

And on top of this broader distribution of political and trade policy risks, the Fed is of course also confronting the confounding, confusing nature of the current inflation dynamics: if the traditionally favored core inflation measures and inflation expectations are both declining relative to practically all the internal staff forecasts, the evidence is hardly pointing to “transient” low inflation despite the belated switch to the more reassuring trimmed mean measures.

After all the fiscal stimulus of tax cuts and a hefty budget boost, how far could inflation fall if growth continues to drift down, perhaps slipping below trend, much less plunge in an outright recession? The data since May’s “patient policy in either direction” has been mostly softer save for the retail resilience of US consumers.

Along that line of thinking, there is still strong undercurrent of the more dovish arguments among a minority of the Committee (see 4/22/19, “Fed: A Pre-emptive Rate Cut “Recalibration”). Their case is still on the table, that a much more pro-active, pre-emptive rate cut or cuts is warranted in order to reset the policy rate below the estimated short run r* levels, both as insurance against the downside risk dragging on growth and perhaps providing a jolt to reverse ebbing inflation expectations. 

So against that sort of backdrop, it has to be said there is at least a tail risk, maybe a 5% chance, the FOMC opts to cut rates on Wednesday despite the political optics of looking to be driven by a quick-to-tweet White House or markets baying for deep rate cuts; or perhaps there could be clearer signals for a more assertive, pre-emptive reaction function teeing up an aggressive July rate cut and be done with all the handwringing. 

Another thought that comes to mind is how the FOMC could play the balance sheet policy before its already announced September end to the asset run-off: we have some sense that if a rate cut was in the cards before September, there may be a willingness to bring the end to the run-offs forward as well. 

And once that Rubicon has been crossed, could the FOMC, against its intent not to use the balance sheet as an active policy tool, opt to dramatically end the asset run-off in a surprise move that underscores a dovish signaling — and boosting the odds on July — but in theory still keeping an optionality on eventual timing to a potential rate move?

Premature versus Pre-emptive Rate Moves

That any one or all three of those scenarios are even being weighed in the expectations for the June meeting outcome tells us just how uncertain and uncharted the landscape is against which the policy decisions are being made. But we think all three are very low probabilities on several counts. 

The first is the actual story in the data is not all that clear cut in that growth may be slowing, but so far not faster or lower than most of the staff forecasts, but it still looks to be running above trend with few clear, stark signs of recession. 

The US consumer, for one, looks to be for the most part still hanging tough. The most recent Nonfarm Payroll print, for instance, was not as bad as it first seemed, and for much of the Fed staff, our impression is that they were battling more to explain why the job creation had not fallen to the estimated break-even levels well before May’s 75,000 print and its revisions of prior months. 

That sanguine outlook could change next month, but until then, so far, it is a slipping but not sliding economy. And even though business investment spending and confidence is clearly taking a hit, primarily due to the debilitating uncertainty of trade effects, it could also just as easily reverse and quickly, depending on a turn for the better in the high stakes, high bluff trade negotiations. 

And for all the fixed income gloom, financial conditions are as easy as they were prior to the “far from neutral” cold water in the face of last October, and the stock market seems to be in a bullish world of its own.

In other words, our sense is of an FOMC that is still unsure of just how bad the outlook is looking and is acutely aware of how quickly the gloom on the policy front could be lifted in a single tweet. And until it sees a clearer new economic story taking hold in the data, we suspect the FOMC is more likely to cautiously protect against a premature rate cut versus taking a bolder pre-emptive cut that could only mean an awkward policy reversal in a need to hike again not too far down the road, and in an election year no less.

And while the Committee minority arguments for insurance cut seems conceptually sound, our sense is of a Committee majority going into the June meeting black-out that is still wary of the move, that it would be too radical a deviation in the reaction function short of immediate crisis conditions and that the persistence in low inflation is by itself enough to move the rates needle, at least not yet. 

Perhaps more crucially, there is a sense of wariness in the communication challenge amid so much political pressure and market pricing and that, all else being equal, we take to be pointing to a preferably longer messaging runway and, again, to a September over July rate cut consideration — at least not without a very forceful case made by Chairman Powell himself.

“They Are Not My People”

We understand Chairman Powell vowed to his central bank peers at the International Monetary Fund meetings in Washington last April that the Fed will do “whatever is right” regardless of the politics and pressures. That, on the face of it, implies taking a course of action based purely on the risks to the Fed’s twin mandates, which one would be forgiven to mean a move to blunt or at least soften the rising downside risks.

President Trump, of course, has escalated his political onslaught against the Fed, voicing his frustration over the December rate hike, the lack of a rate cut to date, and bemoaning that “they are not my people.”

But more than the blunt political attacks, it is the trade policy uncertainty that is putting the Fed into an incredibly awkward position in how it decides to signal its policy stance this week that is less than two weeks before the high stakes June 28-29 G20 meeting. 

While both Washington and Beijing are striving to downplay expectations on a possible trade deal, or even meeting for that matter, the almost binary potential outcomes range from an agreement to extended talks with, crucially, a postponement of the threatened additional US trade tariffs to a lower probability risk of a collapse of the talks that would almost certainly send already slowing growth and falling business confidence and capital investments deeply south.

In that case, President Trump would no doubt get his rate cuts, but the cost and consequences may be well beyond any checks the Fed can write. So, against that sort of risk/reward calculation, we suspect Chairman Powell will err on the side of caution in positioning the FOMC to respond to potential negative fall-out, but not much more than that until the data provide a clearer and more politically protective story.

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