(Wednesday Post-Fed) The Fed’s not in the business of delivering surprises. That’s why today’s 25-basis point rate cut—the second in less than two months after 10 years without one—probably came as most investors expected.
The benchmark fed funds rate is now in the 1.75% to 2% range, back to where it was roughly a year ago, as the Fed pedals furiously to keep the long U.S. expansion going even as economies in Europe and Asia seem to be slipping into slow motion.
The real question is what comes next, and that’s why people are taking a close look at the Fed’s latest statement and “dot plot” to get a sense of whether this is the last cut of the year or if there’s a chance of another. It may be an actual surprise to hear that the Fed itself doesn’t agree on this. With that in mind, it looks like rate policy will remain a “meeting by meeting” decision based on data and the risk picture, Fed Chairman Jerome Powell said in his press conference.
“We’re not on a pre-set course,” said Powell, admitting that this is a “challenging” time.
Lack of a definitive promise for more rate cuts appears to have put stocks under pressure late in today’s session. The dot plot shows five members thinking the Federal Open Market Committee (FOMC) should have held its previous range of 2% to 2.25%, five approve of the 25 basis point cut but want to keep rates there through the rest of the year, and seven favor at least one more cut this year, CNBC noted.
There’s really no easy landing spot, and it’s more difficult because there’s also a bit of a conundrum in the U.S. economy now. “Household spending has been rising at a strong pace,” the Fed said in its statement today, but “business fixed investment and exports have weakened.”
This could be a way of alluding to the trade situation, where tariffs are apparently starting to have an impact on company investment due to uncertainty about how they’ll ultimately play out. Consumers have been keeping things going at home, as the Fed noted by putting stronger language around the spending dynamic this time around, but some analysts believe it’s unclear if this can last beyond the holidays if there’s no definitive outcome on trade.
Powell Notes Weakness Abroad
In his remarks after the decision, Fed Chairman Jerome Powell noted “weakness abroad,” low U.S. inflation, and U.S. business uncertainty in the light of the trade situation. The Fed, he said, has dialed down its ideas of where “appropriate” rate policy should be, and has adjusted to take this into account.
“Global growth has weakened…and political risks like Brexit remain unresolved,” Powell said at his press conference. “Uncertainty about trade policy has discouraged (companies) from investing in their businesses.”
Powell said the FOMC still expects U.S. gross domestic product (GDP) growth to remain “moderate” at near 2% this year and next, and unemployment to stay below 4%. However, he noted that inflation expectations remain at the low end and inflation hasn’t reached the Fed’s 2% goal. He expects the 2% goal to be reached, but in the meantime, “continued below-target inflation could lead to an unwelcome slide in expectations.”
Deflation can be a self-reinforcing psychology, encouraging people to wait before making purchases on hopes prices will fall. That’s the kind of deflationary spiral the Fed hopes to avoid.
Powell says the labor market remains strong, with wages rising “particularly for lower wage jobs,” which is allowing more people to participate in the job market.
However, “Global growth continues to weaken,” even since the Fed’s last meeting, a risk that the Fed sees as more heightened now, Powell said.
Growing Dissent on FOMC Could Make Next Meetings Tougher
It’s also interesting to see a growing dichotomy among Fed voters, with three of them dissenting this time around. One wanted a 50-basis point cut, while two wanted no cut at all. Dissenters included some of the usual hawks and doves.
This is the second time in a row we’ve seen people dissenting, which makes it seem like it could be tougher for the Federal Open Market Committee (FOMC) to reach consensus the next few meetings. What didn’t change from the last statement back in July is the Fed saying it will continue monitoring the economy, a possible sign that FOMC members could simply decide to watch the economic data roll in before deciding on next steps. Last time out, the Fed didn’t satisfy doves who wanted it to announce it’s on a steady rate-cut course, and it seems unlikely that will happen anytime soon.
Another question is where a so-called “neutral” fed funds rate might be. Earlier this year, some analysts and economists thought it was somewhere around 3%. Now, the Fed has taken rates back below 2% and there’s still widespread belief, judging from the futures market, anyway, that it could move rates even lower. Does that mean a neutral interest rate is also edging down, or is the fed funds rate downshifting out of neutral and into low gear?
A “neutral” rate, by the way, is one that’s supposed to neither encourage nor discourage borrowing. The European Central Bank is already offering a rate way below neutral levels, and well below zero. The benchmark U.S. rate remains well above that, but we’ve heard more chatter recently about possible negative rates here lately, with even former Fed Chair Alan Greenspan weighing in on the topic.
Another question mark going into this afternoon’s press conference was the Fed’s future plans for its balance sheet (see more below). Recall that the central bank recently wrapped up a balance sheet reduction program, and already there have been calls for a fresh round of expansion. “It’s certainly possible we’ll have to resume organic growth of the balance sheet earlier than we had thought,” Powell said, noting this is going to be a discussion topic for the Fed.
Laying Out Arguments For and Against
In normal times, it might be unlikely to see rates go down at a time like this. The economy grew nearly 3% last year and is running at around a 2% clip now. That’s not outstanding, but it’s not anything that would necessarily get people worrying about recession, either. Inflation, too, sent some signals last week, with both core producer and core consumer prices rising more than many analysts had expected. Inflation can be a sign of economic strength.
Meanwhile, unemployment remains at 50-year lows. Generally, low unemployment and a growing economy tend to argue against easing borrowing costs, out of fears that the economy could get “too hot,” sparking inflation.
Another argument you could make against rate cuts now is that they’re already ultra-low. With the fed funds rate at just under 2.25% going into the meeting, the Fed doesn’t have a lot of traction to make more cuts if the economy really runs into trouble. There may be some members of the FOMC who’d like to keep the powder dry, so to speak, so they have ammunition to stimulate growth if times get tough.
Historically, the fed funds rate has been around 5%, so it’s about half its normal level. A 5% rate means the Fed could cut a bunch of times if recession hits. A 2% rate means you’re back to zero again pretty quickly. The Fed only has so many bites at the apple before it has to consider more dramatic and less tried and true stimulus tools like quantitative easing or even negative rates.
The factors that had been pointing in the direction of a rate cut included the trade war between the U.S. and China and continued negative rates and poor economic performance overseas. Though the benchmark German bund yield is up a bit from recent lows, it remains way under water. Chinese economic growth continues to sputter, and Argentina is also in tough shape. The Fed might not want U.S. rates to be so far out of line with rates around the world, and the spread between the U.S. 10-year yield and the German 10-year yield is at long-term highs.
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FIGURE 1: RESILIENT GREENBACK. In theory, lower domestic interest rates should lower the value of the local currency relative to other currencies, all else equal. Yet after the second cut in the fed funds rate in as many months, the U.S. Dollar Index ($DXY) has held steady—and even rose a bit. As developed markets across the globe continue to slow, perhaps the market is saying that, despite the dovish moves by the Fed, dollar-denominated investments remain—in the words of one analyst—the best house in a bad neighborhood. Data source: ICE (NYSE:ICE).Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Wages and Recessions: Looking back over the last few economic recoveries, research firm FactSet found that wage growth topped 4% year-over year for long stretches during tight labor markets in the 1990s and 2000s. That hasn’t happened over the last few years despite unemployment falling to 50-year lows, with wages barely rising 3% for many months now and only getting to 4% in one recent month: December 2018. Though you want to see people get paid more for their work, maybe the light wage growth could be a blessing in disguise, because periods of strong wage growth in the past were often followed by recessions, FactSet noted.
Why aren’t wages rising faster? Economists offer all kinds of reasons, ranging from the “gig economy” to competition from internet companies that tends to keep prices from rising as much and might dampen demand for higher wages. There could also be more lingering uncertainty following the 10% unemployment seen a decade ago, making workers less forceful about trying to get a bigger paycheck. Even a striking GM (GM) worker, when asked by the media this week why he’s on the picket lines, said it’s about “jobs.” He didn’t mention pay.
The Almighty Dollar’s Case for a Cut: It all comes down to dollars and cents, as the saying goes. Maybe today’s Fed rate cut works into that old expression, because one argument for easing rates involves the strong dollar and how to get it back down. At this point, with the dollar index not far from recent highs above 99, it could be creating concerns about future U.S. growth. A strong dollar combined with weakness in overseas markets could hurt the U.S. economy from an export perspective by making its products cost more even as economies overseas grapple with possible recession.
The Fed has said it wants to keep the U.S. expansion going and also wants to get inflation back to its 2% target. By lowering rates, it could conceivably weaken the dollar and spark some inflation by influencing companies and consumers to spend more, though that’s just theoretical. The other problem is, no matter what the Fed does or says, the dollar hasn’t budged much in recent months. It tends to be one of the places people go when there’s a “flight to safety,” meaning even if rates go down (theoretically creating a higher supply of greenbacks), people might still want to be long dollar for perceived protection, as the U.S. economy still looks like the best house in a bad neighborhood.
Crude Rallies Don’t Always Hurt Stocks: Consider this: Since bottoming at $26 a barrel in early 2016, U.S. crude prices rose 111% by the end of last week (before spiking Monday after the attack on Saudi Arabia). In that period from early 2016 through mid-September 2019, the S&P 500 Index (SPX) rose roughly 60% and the economy has grown pretty steadily, with unemployment falling to 50-year lows and consumers in very good shape. So you could argue that stocks and the overall economy sometimes do just fine even as crude climbs. There’s a limit, naturally, but even when crude was above $100 for a few years, the economy didn’t stop growing. With Saudi Arabia now saying it might be back to normal oil output in just two to three weeks, crude prices stepped back Tuesday and Wednesday, but it’s not prudent to get complacent. Crude is likely going to carry more of a risk premium than before, especially with the Gulf situation so volatile and the U.S. threatening new sanctions against Iran.
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