Fed: October Recalibration

Published on October 22, 2019

Judging from the surprisingly disciplined messaging going into the pre-meeting blackout period by various Fed officials on a “meeting to meeting” approach, the October 29-30 meeting of the Federal Open Market Committee looks to be more finely balanced than any in recent memory.

*** While our sense is that a solid FOMC majority — and that includes the dovish-leaning Board — would prefer a longer run of data to December before making their next rate decision to gauge the effects of the accommodation to date, we think Chairman Jerome Powell will keep his eyes on the prize of “sustaining the expansion” and steer a majority Committee consensus to err on the side of further cautionary accommodation. We now think the probabilities have modestly tipped to a third rate cut “recalibration” next week that will bring the policy rate down to a 1.50%-1.75% fed funds target range. A repeat two dissents seems likely. ***

*** We suspect the larger debate will in fact be over the statement language and presser messaging. A majority of the FOMC have been skeptical of the “insurance” argument for the July and September rate cuts, and are likely to make the case for clearer evidence of weakening data before a next rate move. But we expect a majority Committee consensus will be crafted in a compromise on the messaging, namely, that the rate cut is more to offset the early but hardly conclusive softening in recent data and inflation expectations than it is a, perhaps last, insurance ease against still elevated, mostly trade, risk probabilities. ***

*** With the jury still out on whether the slowdown in global growth and US manufacturing is spreading into broader consumer spending and aggregate demand, we think a “hawkish cut” is unlikely. Chairman Powell, we think, is likely to maximize the fed’s policy optionality going forward by balancing his messaging between conveying the Committee’s confidence they have “re-centered” the policy rate relative to the risks and base case forecast, while still leaving the door open to further, albeit data-driven, accommodation. Indeed, with little to no upside risk, that is the intended takeaway in reaffirming the Fed will “act as appropriate.” ***

The Case to Wait Until December

We had previously been putting a rate cut next week at even odds (SGH 9/26/19, “Fed: Disparate Perspectives” and more recently in SGH 10/4/19, “Fed: An on the Mark NFP”), primarily because our sense was that, in contrast to the July and September rate cut majority decisions, the Committee was genuinely undecided on the merits this time, reflecting a somewhat higher hurdle to further accommodation.

For one, the more hawkish-leaning Committee members have consistently stressed that when stock prices are this high and credit spreads aren’t particularly elevated, lowering interest rates in such a late stage of the expansion may be encouraging excessive risks that could come back to haunt if economic growth should slip to stall speed or worse. And more to the point, they add, monetary policy is simply not the appropriate response to counter the effects of the trade war uncertainties on business confidence and investment spending.

It has been our sense in fact that a majority of the Committee have been somewhat skeptical of the arguments for easing in order to soften the effects of the trade uncertainty erosion of business spending — the so-called “insurance” argument — and there is indeed a strong preference across a Committee majority going into this meeting to pass on a rate move in October in order to see the longer run of data into the December meeting.

Federal Reserve Bank of New York President John Williams, for instance, noted just before the start of the pre-meeting blackout that policy operates with a lag, a point straight from central banking 101 but usually repeated by hawks or in this case we suspect, conveying a consensus sentiment.

They have, by their account, already injected a considerable degree of accommodation into the economy since the January policy pivot, culminating in the two rate cuts so far. It should put the policy rate modestly under a consensus short run r* estimate that is no higher than 2.4%. And while so many data points have recently been to the weak side, suggesting early evidence of the trade damage spreading into the broader consumption side of the economy, there remains a view within the Committee that none of the data in what tend to be volatile series have veered well south of the confidence bands to the base case projections.

It is just too early yet, in other words, to have seen any but a most preliminary effect of the earlier easings or to judge whether more is needed, especially when payroll employment is still solid and the headline unemployment rate, whatever you may think of a flattened Phillips Curve, is down to a near record post-war low of 3.5%.

Yet, One More “Recalibration” Seems Likely

But as convincing as the arguments to wait it out before making a rate decision, we think the Committee will in the end err on the side of caution by easing a third time this year. We suspect a key case that will be made is that while it is certainly too early to fully assess how far the accommodation this year is reaching into the real economy, the clearly softening data in recent weeks in the ISM prints, the retail miss, and not to mention a further erosion in inflation expectations, are hardly good signs for the economic outlook.

More to the point, some staff work points to two things: first, that the accommodation is indeed already working in helping to spur demand in the interest-sensitive sectors of the economy and that without that spur to spending, GDP growth would have already slipped below trend. In that sense, the cuts are still helping sustain enough consumer spending to at least partially offset the trade hit to growth.

Second, and even more pressing to the case for modest further easing is the concern that consumer spending is essentially at peak, and is unlikely to continue offsetting the trade war damage to the manufacturing sector without continued, modest monetary policy support. It means to “sustain the expansion” — a phrasing we suspect will be threaded across Chairman Powell’s lawyerly, precedent-rich language to put his weight to the case for a cut — may mean adding a modest bit more accommodation is needed to keep the long arc of accommodation ever since the January policy pivot nursing the most interest-sensitive spending.

And by easing one more time, now, rather than waiting for clearer data evidence, it provides a relatively near low cost “modest accommodation” that in effect, buys time until a more comprehensive assessment of the policy stance in December. The dovish contingent in the Committee will also argue that if they are wrong, and the easing is not needed, the Fed can always take it back with a rate hike or hikes in, well maybe not 2020, but certainly 2021, and if lagged and helping to stir higher inflation expectations, so much the better.

The “Insurance Channel”

Whether the entire Committee truly buys into the “take it back” argument is probably a stretch, but it does go to the insurance argument. Despite the skepticism that seems to run across much of the committee over the merits of “insurance” cuts before there is clearer weakening of demand in the data, for a muscular minority of the Committee, the insurance element will remain a factor in next week’s decision.

That so-called “insurance channel” is seen to work on several fronts in addition to the more straightforward support to interest sensitive spending. For one, it is reducing the costs in uncertainty, which almost by definition invariably translates into a lower short run r* and the need for matching accommodation to offset some of the risk aversion by lowering the hurdle rate and the potential cost of chancing an investment.

But where this current policy reset is true insurance is as a relatively low cost “down payment” to a more sustained accommodation that may still loom: if the data should be slipping south, sliding towards a stall speed below trend or worse, the full FOMC, including the more hawkish-leaning, will embrace the sort of “swift and aggressive” rate cuts mapped out in the so-called “Reifschneider-Williams” playbook that we have previously noted (see SGH 9/16/19, “Fed: The September Meeting”).

In that sense, whether 50 or 75 bps of cuts before a “tipping point” would be a “front loading” of the larger, more muscular accommodation that would be modeled to stay in place over a stretch of years if the worst-case scenario should be unfolding. No one on the FOMC see that as likely, but the point is that they will all want to retain maximum policy optionality going forward.

And it is exactly because the outlook is so uncertain, the forecast so binary between a narrower but weak manufacturing sector and a still resilient, for now, but broader consumer side, that we believe the FOMC is very unlikely to map out a “hawkish cut” by signaling they are mostly finished on further accommodation. Not even the most fiercely felt hawk would argue for that.

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