Fed: Insurance

Published on September 18, 2019

Two things leap out for us from this afternoon’s statement, Summary of Economic Projections, the rate dot plots, and Federal Reserve Chairman Jerome Powell’s opening remarks and responses to reporter questions.

** The first was we thought it noteworthy that Chairman Powell described the rate cut as “insurance” perhaps as the way to metaphorically navigate out of the “mid-cycle adjustment” phrasing that caused so much consternation in July. But they are essentially saying the same thing: the Fed is easing rates back below the best estimate of the short run r* to put some accommodation back into the economy to improve the probabilities for a sustained expansion.

** And while Chairman Powell struggled a bit to stick to the script in avoiding an affirmation the FOMC has an easing bias going forward — that said, the FOMC does have an easing bias: the 2019 rate dot median going into the meeting may have showed a ten member Committee majority who marked either no more cuts at all, including two voters, or they are done after today’s cut, seven Committee members marked two more rate cuts this year, including today’s rate cut, as the appropriate policy path — and all seven are most certainly voters.

** Chairman Powell also affirmed the FOMC would cut if the data shows the economy weakening — but which is not the Fed’s base case — and more importantly, we believe that if the probabilities for any or all of these downside risks rise to the point of discomfort, the FOMC is more likely than not to drop rates by at least another 25. The difficulties and judgement call on the risk management calculation on which data points mark the tipping point is why the FOMC members are paid the big bucks.

Real Economy Looking Pretty Good

Another thing for us that was striking, or at least interesting, was that the median real growth was marked slightly up, not down, in 2019, and the same in 2021, while the median growth projection in 2020 was left flat rather than being marked slightly down as might be expected in light of the hit to manufacturing and business investment.

And not to push back too hard against the prospects for even deeper rate cuts, the FOMC is pointing in the exact opposite direction in its median appropriate policy rate path. The median of the rate dot plots further out in 2021 and 2022 are both showing rate hikes, one and two rate hikes respectively, even though growth and unemployment were both forecast below the longer run trend growth and longer run unemployment estimates.

That view was underscored by the generally more upbeat take on the economic outlook in the opening descriptive paragraph of the statement: the labor market remains “strong,” economic activity has been “rising,” and job gains have been “solid;” all of that stands in contrast to the unspoken trade effects that meant “business fixed investment and exports have weakened.”

Indeed, reflecting the downside risks hanging over the real economy in US trade policies, Brexit, and now a highly volatile Mideast — none of which were cited in the statement but each popped up here and there in the presser — meant “uncertainties about this outlook remain.”

The reason, of course, that the growth forecast could be kept at the current trajectory and above trend was the Fed’s dramatic pivot in the likely rate path since January that has validated to quite an extent the market’s even more dovish pricing that has provided plenty of monetary accommodation to take out some of the tail risk to a recession.

And that, in a nutshell, is the whole point of these two “insurance cuts” — and which could still be potentially extended to include a third cut before year-end or perhaps early next year. By reasserting the FOMC stands ready to “act as appropriate” the markets should take it to be implicitly signaling one more insurance cut is possible; after all, in theory, there is little prospect in all the risk falling to the downside that to act as appropriate might mean moving rates higher.

Promising a Balance Sheet Review

One last thing is the FOMC’s response to the stress in the short rates market and the overnight General Collateral Repo market in particular: as expected, the Board of Governors voted to lower the interest on required and excess reserves to 1.80%.

Likewise, as we wrote likely (SGH 9/18/19, “Fed: Addressing Repo Stress”), the broader FOMC also refrained from bringing forward the eventual expansion of the balance sheet today, but Chairman Powell promised internal deliberations in the run up to the October meeting on the matter of whether the Fed may have to resume its organic balance sheet growth earlier than thought.

It was also noteworthy to us that in watching bond, equity and currency movements, his carefully phrased promise for that inter-meeting discussion on expanding the balance sheet looks to have had an immediate calming effect that would make for a neat book-end to the sharp market dislocation in the immediate wake of his December meeting shrug that the balance sheet policy was on auto pilot. You live, you learn.

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