Despite the chatter across volatile markets to the contrary, there is little prospect for an inter-meeting rate cut by the Federal Reserve in the coming days or on the sidelines of next week’s Federal Reserve Bank of Kansas City’s conference in Jackson Hole.
*** Our sense is that Fed officials, for now, would see a rate cut in the current conditions as potentially counter-productive. While financial markets may initially welcome an inter-meeting cut, it could still be misinterpreted in the real economy as signaling things are truly turning for the worse, adding to the uncertainty rather than easing financial conditions or cushioning the real economy. ***
*** That makes a second 25 basis point rate cut at the mid-September FOMC meeting, to reset the policy rate modestly back below the best estimates of neutral, as the most likely near policy path. To lower tail risk, an optionality would also be signaled that “swifter” more aggressive rate cuts would still be on the table if the data truly worsen or downside risk probabilities become even more elevated. ***
Trade Policy Uncertainty Driving Market Fears
As dramatic as the market swings and yield curve inversion has been, there is a sense among most Fed officials that the current market conditions are still nothing like 2008, in which a lack of access and elevated counterparty risk were seizing up the global credit markets and triggering a sharp, rapid pullback in economic activity.
The big reversals in the stock markets and even the eye-catching yield curve inversion of recent days are instead being seen as primarily driven amid thin August liquidity by a singular fear over the immense policy uncertainty of the next twist or turn in US trade policy, to what extent China will retaliate, and which could still be reversed in minutes.
Indeed, the data in the underlying real economy still looks relatively resilient, slowing moderately but nothing to suggest deep rate cuts are needed to stem a steep slide in aggregate demand. This morning’s strong retail sales number further reinforces that assessment.
Certainty in the Reaction Function
There is, to be sure, an important psychological factor the FOMC will have to weigh, namely whether a well-timed, appropriately-sized rate cut could break a downward spiral where panicked market flight to safety and falling confidence in a resolution to the trade wars could spill over into equal fears among corporate decision makers.
That, in turn, could lead to a slower growth in investment spending that gathers momentum into an outright decline in aggregate investment spending and eventual job layoffs that would finally undermine consumer confidence and spending.
Adding to the FOMC’s near judgment call is the complication of the proximity to the zero lower bound and that, after the big run up in the federal deficit to fund the 2017 corporate tax cuts that look to have had only a limited longer term impact, neither fiscal nor monetary policy makers have much ammo to counter a true recession. The best way then to fight a recession is to do what you can to lower the odds it will happen in the first place.
But from what we understand the current FOMC consensus to be, all of those factors taken together are still translating into a near policy path to stay the course, show calm, and to focus upcoming policy messaging on providing a sense of certainty in the central bank’s likely reaction function to the data and to risk probabilities, rather than a certainty to the rate outcome itself.