The sudden rush of headlines this morning on European Central Bank President Mario Draghi’s “materialization of risk” remarks in Sintra and President Trump’s tweet confirming an “in-depth” meeting with Chinese President Xi at the G20 meeting both came just as the Federal Open Market Committee was sitting down to start their two days of policy discussions.
*** At the outset, while the knee-jerk pop in market pricing for higher odds on a Fed rate cut tomorrow is not entirely out of line, on balance, we still don’t think a rate cut announcement is likely tomorrow afternoon. Instead, we suspect the combined Draghi-Trump effects will be to reinforce the easing bias of the statement with a greater accent on global downside risks, and to deepen Chairman Jerome Powell’s soothingly, reassuring dovish tones in his presser. ***
*** But we do think the ECB’s heightened dovishness, as well as the easing signals from other central banks, will invariably elevate the odds for a July rate cut. The Fed’s almost luxurious July to September time frame to consider a rate cut will be telescoped more tightly into a much more likely July decision. Barring a shock downturn in the data next month, a mid-summer rate cut would be by 25bp rather than a panicky-looking 50bp. ***
Two points are shaping our read on the Draghi-Trump two punch impact on the FOMC deliberations now underway:
First, in terms of the Draghi effect on the Fed’s policy deliberations, we suspect the likelihood of further weakening in the Euro will significantly bolster the concerns by the Committee minority (see SGH 4/22/19, “Fed: A Pre-emptive Rate Cut ‘Recalibration’”) over the risks in the persistence of the low inflation and especially the clearly ebbing inflation expectations.
If unchecked (by a Fed easing), they will no doubt argue, the exchange rate effects of the Euro and other currencies is likely to drive US inflation and expectations down even further, and that it may be too late to wait until a preferred September meeting before making a rate move in order to see if the data confirms a slowing economy beyond what is already forecast.
By then, the risk would be falling inflation expectations becoming entwined with any faster or deeper than expected slowdown in the economy. And that could easily translate into inflation expectations unanchored to the downside and an even more deeply entrenched low inflation pinned well under mandate-consistent levels.
So in that sense, Draghi’s speech is likely to push their concerns to the center of the table and while we simply cannot rule out a, say, one in five, chance the FOMC opts to cut tomorrow to be done with it, we still think it is more likely to ensure the very dovish takeaways tomorrow and lift the probabilities for a rate cut in July, in something of new version of the old argument about preemptive insurance rate cuts.
Second, our sense of Draghi’s intentions with the speech was more or less to align alongside the Fed in laying down a blanket of insurance against downside risks threatening to overwhelm the global outlook by vowing a readiness to act as needed. Draghi was explicit in mapping out a timeline over the coming weeks, in effect, laying the internal groundwork for the rest of the Governing Council to come along for what will be a cut on the table at the next meeting.
Draghi was not, in other words, undertaking a messaging competitive devaluation to get in front of the Fed. Instead, our sense is of both central banks, we believe, shifting hard into unmistakable twin easing biases — but stopping short of certainty or firm commitments to cut rates in July — in order to better position for any risk of a downside shock in the trade talks, now apparently being formally arranged, between Presidents Trump and Xi on the sidelines of the June 28-29 G20 talks.
Finally, confirmation that Presidents Trump and Xi are meeting at all in itself is probably diminishing the risk of a downside shock in the talks collapsing altogether. The base case scenario remains one of extended talks and, crucially, for President Trump to postpone the threatened additional trade tariffs with China.
If that is to happen, it would free both the Fed and ECB to focus on the longer-term impact on the respective real economies in the negative drag of the likely prolonged trade uncertainties on business confidence and capex and what that will do to aggregate demand next year. That would still point to an easing to pull the policy rate safely back below short run r* estimates, but easier to communicate free of the credibility-undercutting optics of political pressures.