Fed divided ahead of key meeting

Market participants seek clues and validation

It seems clear the Federal Open Market Committee meeting on 18 September will result in a further 25 basis point cut in the federal funds rate.

The relevant question is what the Federal Reserve signals about the rate outlook beyond this month. Market probabilities for the period following the September FOMC point to expectations of at least two further 25 basis point cuts through the end of 2019 or early 2020. Market participants, seeking clues and validation, will focus on the FOMC statement and Fed Chair Jerome Powell’s subsequent press conference.

Uppermost on their minds is whether there will be a hawkish or dovish cut, or whether Powell will maintain optionality. It is difficult to predict. The tug of conflicting forces is strong and the FOMC seems divided. Several regional Fed presidents have suggested a preference for a pause, while others point to the need for further cuts.

The case for a subsequent pause or more restrained path for cuts rests largely on ‘data dependence’ and the current economic situation.

The US economy was long expected to slow toward potential this year. It has, but it is holding up relatively well and sustaining activity far better than abroad. Consumption accounts for 70% of US economic activity, and is being propelled by solid disposable income gains reflecting continued low unemployment, well below most estimates of the natural rate. Even in the face of a more modest pace of disposable income gains, consumption could be cushioned by reduced personal saving.

Manufacturing is weakening, but accounts for little more than 10% of the US economy. The far more dominant service sector has been performing relatively well.

Inflation measures are generally consistent with the Fed’s 2% objective. While the central bank’s preferred core consumer price index measure is somewhat below 2% on a year-over-year basis, recent months on an annualised basis are slightly above 2%. Other CPI measures are as well. The outlook for prices by most measures is, however, restrained.

With unemployment below its natural rate and inflation generally in line with the Fed’s objective, the Fed is meeting its dual mandate.

Additionally, US financial conditions remain highly accommodative. Various trade tweets have increased volatility and sent stock prices reeling. But equities have rebounded and steadied around recent highs.

Analysts question how impactful monetary policy actions are as the zero lower bound is approached, and want to retain ‘bullets’ for any recession. Some ask whether low rates may contribute to potentially harmful froth in markets.

The case for vigorous monetary accommodation is also clear.

President Trump’s trade wars are directly and indirectly reducing growth at home and abroad. Uncertainties surrounding further trade actions are harming global investment. A Federal Reserve staff paper recently concluded that firm level estimates suggest uncertainty around trade policy may have lowered aggregate US investment by more than 1%.

The global economy is clearly slowing and facing downside risks, again in large part due to fallout from US trade wars. China has been a global engine of growth, accounting for one-third of global GDP growth in recent years. China is not only moving down to a more sustainable growth rate. Deleveraging, a weak financial sector and trade wars are dampening activity. Germany may be in recession. Brexit woes further undermine the European economic outlook. Italy always lurks as a risk. Japanese growth, already very modest, will be hit in coming quarters with a consumption tax increase.

The global economic and financial systems have spillback effects on the US. The latest services purchasing managers’ index reflected softness, while payroll gains in August were modest.

Monetary policy must be conducted in a forward-looking manner, but it is impossible to know definitively what the future holds.

FOMC communication will thus be even more important than usual. Reiteration of language about a ‘mid-cycle’ adjustment could be interpreted as a hawkish signal and upset current market expectations. Rhetoric pointing to large global risks and uncertainties and the need for insurance to guard against a downturn might validate the market’s outlook. If the FOMC goes down this latter path, rather than simply reciting these risks, it should clarify far more transparently and in detail how much weakening it foresees in its outlook, and how impactful trade and global uncertainties are for the relatively closed US economy.

Recent statements from Powell about acting appropriately to sustain the expansion appear aimed at veiling his intentions. Seemingly, the outcome still lies in the balance.

Mark Sobel is US Chairman of OMFIF.

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