No one wants the Fed Chair to be inappropriate. Jerome Powell has been the very model of decorum in his testimonies to Congress and other speeches, yet he feels the need to remind the public continually that the Fed will “act appropriately.” 1 1 Close For example, in a recent speech Fed Chair Powell stated the Fed “will act as appropriate to sustain the expansion” in the U.S. Source: Federal Reserve, Chair Jerome Powell: “Monetary Policy in the Post-Crisis Era,” 7/16/19. At "Bretton Woods: 75 Years Later—Thinking about the Next 75," a conference organized by the Banque de France and the French Ministry for the Economy and Finance, Paris, France. Market participants rightly take the recent use of this phrase as a signal that the Fed will ease monetary policy at its next meeting. For folks who take a quantitative view on monetary policy (and you know who you are), it doesn’t seem all that appropriate for the Fed to be loosening policy. The most popular formula for estimating monetary policy, the Taylor rule, looks at monetary policy as a function of employment (or growth) and inflation. Right now, inflation is a little below target, but the labor market is tight, so most versions of the rule would call for higher rates. 2 2 Close If you assumed a very low non-inflationary rate of unemployment or put a very high co-efficient on inflation, maybe you could get to a cut, but it would require some financial engineering to have a version of the Taylor rule which implies rate cuts. Of course the Fed only uses formulas as a guide; its reaction function is flexible. In other words, it can do whatever it wants. The question facing markets is why it wants to cut rates now.
The first consideration in any Fed decision is the economic data. The picture there is mixed. Employment numbers have been good, but some leading indicators are less rosy. For example, Manufacturing Purchasing Managers Indexes are well below where they were a few months ago. The yield curve is inverted. Powell has warned of uncertainties in the economy, but he hasn’t always been consistent on the details. In a speech earlier in the week he mentioned his old favorites including trade, global growth, Brexit and low inflation. Then he added one we haven’t seen in a while: the U.S. federal debt ceiling. 3 3 Close Federal Reserve, Chair Jerome Powell: “Monetary Policy in the Post-Crisis Era,” 7/16/19. At "Bretton Woods: 75 Years Later—Thinking about the Next 75," a conference organized by the Banque de France and the French Ministry for the Economy and Finance, Paris, France.
His updated list doesn’t seem all that frightening. Economies around the world have been sluggish, and it’s no secret that trade is a threat to global growth, but none of this seems so pressing that it requires immediate action. Powell himself admits that the economy is in a “good place.” While acting aggressively wouldn’t be unprecedented, these concerns would have been unlikely to draw rate cuts in past cycles. 4 4 Close There are some reasonable analogies where the Fed cut rates when economic data was okay, but each time there was something more immediate like a giant hedge fund collapsing or an EM crisis. It’s really a matter of opinion whether those analogies are appropriate. This may lead the most cynical of us to think that the Fed is bowing to executive pressure to cut rates. It is impossible to know what is in Fed members’ hearts and minds, so we can’t say conclusively that they aren’t influenced. However, the Fed sees some meaningful differences in this economic cycle. These differences may be more important to decision making than feeling bad about being called clueless.
Current Fed policy rates are lower than they were at the peak of any other cycle in the past sixty years. 5 5 Close Bloomberg, Federal Reserve. In fact, they are below where they were at the troughs of many these cycles. At first glance it would seem that low rates would make the Fed less likely to cut rates quickly. Some critics have argued that the Fed should use rate cuts sparingly in order to save its bullets for real emergencies, but most Fed members don’t share this view. 6 6 Close Some have taken it further and said the Fed should hike rates more to give them room to cut later. I am not a fan of this argument. It’s like saying you need to break your arm so you have room to put it in a cast. It may seem counterintuitive, but lower interest rates actually make the Fed more likely to cut early. The reason is the dreaded zero lower bound.
The zero lower bound refers to the difficulty in bringing nominal rates to negative levels. For many years it seemed impossible to cross the line and charge banks for deposits. Central banks in Europe have proven that conventional wisdom was wrong, but the Fed seems reluctant to follow their example. The problem for the Fed is that if economic conditions get significantly worse, the Fed may not have any good alternatives. Instead of getting into a situation where the members have to consider unorthodox measures such as QE or negative rates, they would rather act in advance to prevent having to make that choice. They may believe that old saying “an ounce of prevention is worth a pound of cure.” 7 7 Close Or something like 75bps of early rate cuts are worth a trillion dollars of asset purchases.
Interest rates are low because of weak inflation and near-zero real rates. 8 8 Close It’s been a while since I’ve put a good tautology in the summary. Fed members don’t think they can do much to affect real rates, but they believe they can influence inflation. It would be silly to have an inflation target and not have the tools to achieve it. There’s been a ten-year expansion and by some measures, inflation is still below target. An unbiased observer might say that they haven’t achieved their target. They can’t help but reevaluate their framework and consider whether they should attempt to get inflation higher.
This combination of below target inflation and fear of the zero lower bound is driving the Fed to act preemptively. The Fed wants to cut rates when the economy is still okay, so it can stoke higher inflation. Only after the Fed can get inflation at or above 2% for a reasonable period, can it then move rates higher and escape the zero-lower-bound. The Fed wants to be credible on its inflation target so it no longer has to worry about deflation. In other words, the Fed can lower rates to get higher rates later. It’s like Lightning McQueen turning right to go left. 9 9 Close If you didn’t get that reference, you probably don’t have a son between the ages of two and seventeen. Or have the good fortune not to have seen Cars over a hundred times.
The Fed has to be careful not to take this logic too far. If inflation is too low and the economy needs a jolt, maybe a 50 or 75bps cut would be more effective than 25bps at the next meeting. 10 10 Close Why not go 100 or 200bps? New York Fed President John Williams made this case on Thursday, then had his office walk it back later. It is difficult to argue that a preemptive rate cut in a growing economy should be so aggressive, but there is support among certain Fed members, at least in theory. 11 11 Close There are some past times, such as November 2002, when the Fed surprised the market with a 50bps insurance rate cut, so it is not unprecedented. For equities, however, a preemptive Fed is very welcome. It means there can be easy credit without a recession, the ideal combination for asset prices. Still, markets may be relying a little bit too much on the Fed to help them. It’s just not appropriate to think that lower rates can solve every problem.
What We Are Watching
U.S. Durable Goods Orders (Thursday)
After two years of stronger growth, durable goods orders in the U.S. have been slowing over the past year. Looking at the headline data (which includes the more volatile transportation sector), durable goods orders declined -3.2% YoY in May. 12 12 Close U.S. Census Bureau. The “core capital goods” measure in the durable goods report, which removes aircraft and defense orders, dipped into contraction territory in April, but bounced back marginally to show growth in May. Increased trade uncertainty, slower global growth, weakness in global auto sales and a slowdown in aircraft orders in the U.S. have likely all contributed to the slowdown in durable goods demand. A positive surprise in this week’s data could help ease concerns of slowing economic growth and may encourage market participants to scale back expectations for Fed policy easing.
European Central Bank Meeting (Thursday)
Eurozone inflation has been below the ECB’s target over the last few years, and recent downgrades to growth expectations have shaken the central bank’s confidence that the target will be achieved moving forward. At the ECB’s annual forum in Sintra last month, President Draghi declared that “in the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required.” 13 13 Close ECB President Draghi: “Twenty Years of the ECB’s monetary policy,” ECB Forum on Central Banking, Sintra, 6/18/19. President Draghi emphasized that policymakers still have multiple tools to provide stimulus. While the ECB’s deposit rate has been steady at -0.4% for over three years, the central bank does not see this as a lower bound and will consider “further cuts in policy interest rates and mitigating measures to contain any side effects.” The recently concluded asset purchase program “still has considerable headroom” should the central bank choose to resume its bond-buying. The ECB may choose to wait until September, when its new quarterly forecasts will be published, to launch new stimulus measures. At the July meeting, market participants will be looking for greater clarity on which of the ECB’s tools will be deployed first, as this could have implications on regional fixed income markets and the value of the euro. The details of “mitigating measures” for negative rates may also impact prices for bank stocks in the region.
U.S. GDP (Friday)
Next week’s GDP release will provide an update on growth as the U.S. marks the 10th anniversary of the current expansion, making it the longest in U.S. history. The data is likely to show mixed performance. Solid growth in the first quarter was driven by net exports and inventories, volatile components that do not reflect the state of final domestic demand, 14 14 Close Final domestic demand includes household consumption, government spending, and fixed investment activity. which grew at a sluggish pace. GDP growth in the second quarter appears to have softened, as concerns about trade tensions contributed to weak manufacturing output and decelerating business fixed investment. Offsetting some of this weakness, household consumption seems to have recovered sharply following a soft first quarter and may reduce downside risks to headline GDP growth. A strong result might cause investors to question the magnitude of rate cuts currently priced into U.S. fixed income markets.