After raising interest rates four times last year, the Federal Reserve has taken a more cautious approach to monetary policy in 2019.
Concerns about the economic implications of President Donald Trump’s willingness to use trade tariffs in disputes mean downside risks to growth are building. On Wednesday 19 June, analysts can expect the Fed to signal that precautionary rate cuts are imminent. Markets favour a 25 basis point rate cut in July, with three additional rate cuts over the next 12 months.
The underlying strength of the US economy, and the likelihood that Trump will want to sign a trade deal ahead of next year’s presidential election, urge caution about the prospect of two 25bp moves in the second half of 2019.
US-China trade tensions continue to intensify, and prospects of a deal being reached later this month are limited. Beijing will not want to be seen as having been bullied into agreeing to Washington’s demands, while Trump’s view that tariffs are boosting US Treasury coffers and that the ‘strong’ US economy can withstand near-term pain suggests he is not going to back down either. Tariff increases seem probable.
Faced with the uncertainty of an intensifying trade dispute and the higher costs and weaker profit outlook it generates, many firms may act more cautiously. This implies a slowdown in investment and hiring, which in turn leads to lower consumer spending and the threat of an economic downturn. Recent data already suggest the US economy is more vulnerable to the fallout than it was in the second half of 2018, with payrolls having softened substantially and manufacturing data looking weaker.
Since January, the Fed has signalled a willingness to be ‘patient’ on assessing whether a change in interest rate policy was going to be required. However, Fed Chair Jerome Powell has already laid the groundwork for a shift in stance by suggesting officials were now ‘closely monitoring’ the implications of the protracted trade negotiations for the economy.
St. Louis Fed President James Bullard, a voting member on the Federal Open Market Committee, was more direct. He argued that a rate cut ‘may be warranted soon’ to provide some insurance in case of a ‘sharper than expected slowdown’. Other officials, including Chicago Fed President Charles Evans, continue to talk about the economy’s ‘solid’ fundamentals, though he too acknowledged that the Fed can adjust policy ‘if that’s necessary’.
Markets can expect some downward revisions to the Fed’s inflation forecasts to reflect the recent benign readings. This backdrop then gives policy-makers greater scope to signal an easing bias within the so-called dot-plot diagram of individual FOMC members expectations for interest rates.
At the last forecast update in March, four members expected rates to be raised 25bp this year with two looking for 50bp of increasing and 11 expecting rates to be left on hold. Ten FOMC members expected an increase of some form next year, while the longer-run expectations were for the Fed funds rate to settle at around 2.8%. The Fed seems poised to put two rate cuts in for this year with stable policy next year, thereby lowering their profile by 75bp against March.
Markets are anticipating around 100bp of easing over the next 12 months, with the first cut around 80% priced for July. This may be a little too aggressive; two 25bp moves in September and December seem more probable. However, should the Fed warn of outright downside risks to growth this week, those moves may have to begin as soon as July.
James Knightley is Chief International Economist at ING. This is an abridged version of an article that first appeared on ING THINK.