July 31, 2019

There is a saying that the Fed dictates rate increases and the market dictates rate cuts.  Coming into July 30-31, the markets were pricing about 65 to 70 basis points of rate reductions by the end of 2019, with another 25 basis points, or more, during the first half of 2020.  The FOMC did not disappoint at the meeting, reducing the target fed funds range from 2.25% - 2.5% to 2.00% - 2.25% and cutting the Interest On Excess Reserves (IOER) from 2.35% to 2.10%, as widely expected.  The fed had shifted from data-dependent to data-expectant, calling it risk management.  The policy move came even after a string of strong data in July, persistent labor market strength, better than expected retail sales, elevated consumer confidence, and equity markets reaching new highs.


Yield Curve


Economic growth to date is largely holding up fine but the Fed has been expressing concerns about increasing downside risks to the outlook stemming from weaker global economic activity, a strong dollar, and elevated trade uncertainly leading to a significant slowdown in the U.S., as well as inflation continuing to fall short of the 2% target.  The “insurance” rate reduction is an attempt to cushion the economy against global economic headwinds and sustain the longest expansion on record.

Leading Economic Indicators

The Fed does whatever it takes to fulfill its mandate of full employment and stable prices.  With the unemployment rate at 3.7% and core PCE inflation at the 1.6%, the Fed is close to meeting its goals.  However, the Leading Economic Indicator, a key barometer for the direction of the economy, is losing momentum.  Historically, an economic downturn has not come without a declining LEI, but a declining LEI has not always resulted in an economic downturn, acting more like as a signal that growth will remain lackluster.  The Fed believes that the best way to meet its mandates is to sustain the economic expansion by making a pre-emptive move to prevent further weakening.

LEI Advianced 18 Monthas

The U.S. economy’s growth has downshifted, GDP slipped from 3.1% in the first quarter to 2.1% in the second.  With a global headwind remaining threatening, the FOMC cut rates for the first time since December 2008.  The Committee also decided to align the balance sheet with a more accommodative stance and announced that it is ending its balance sheet reduction on August 1, two months earlier than previously indicated.  Two Committee members dissented against the policy action and preferred keeping the targeted fed funds range unchanged, given the outlook for the economy and the risk of financial imbalances.

            The post-meeting policy statement did little to settle the debate on the future path of monetary policy.  In his follow-up press conference, Fed Chairman Powell seemed to push back on markets expectations of an aggressive easing cycle by the Fed.   He said the rate cut had an insurance aspect and was in response to external “threats to what is clearly a favorable outlook”.  He also characterized it as “mid-cycle adjustment” and not the beginning of a lengthy rate cutting cycle.  Further, he said the accommodation adjustment was not limited to just one rate cut, however, leaving the door wide open for another quarter point cut this year. On the other hand, he also said the Fed could reverse course and hike rates again before calling a close to the current economic expansion, which has now become the longest on record.