Fed Spikes the Punch in July

The Federal Open Market Committee (FOMC) is expected to cut rates by one quarter percent at its July policy meeting. That will bring the top range of the Fed funds target back to 2.25%, the same as it was prior to the last hike in rates on December 19, 2018. Federal Reserve Chairman Jay Powell will cite several reasons for the ease: a desire to add a little to an economy still running cool relative to the 2% inflation target, slowing growth abroad with the risks that poses to our growth and a boost of confidence from the Fed to offset the drag created by ongoing trade tensions including tariffs and Brexit.

Members of the FOMC are also concerned about financial stability but the vote on what to do is split. Some worry about what could happen to financial conditions if they don’t ease. Much of the easing of financial conditions that we have seen since the market seized last December can be attributed to a promise by the Fed to be more flexible and cut before the economy actually slows dramatically. That view is not unanimous. Boston Fed President Eric Rosengren has been particularly outspoken about his desire to hold the line on rates. He will likely dissent when the Fed cuts rates this month.

The dissent does not stop with Rosengren. There are a minority of members of the FOMC who worry that a cut now has its own set of risks. A dissent also sends an important message to financial markets that the Fed still makes its own decisions, independent of White House bullying.

Officials are not expected to provide new guidance about balance sheet operations at this meeting. Financial markets could become nervous about the Fed’s balance sheet operations come year-end. Lest we forget, it was one word, “autopilot,” which Chairman Powell used to describe the Fed’s balance sheet operations in December, that triggered a market sell-off.

The statement following the July cut is expected to affirm the economy’s strength and the Fed’s commitment to “sustain the expansion,” a goal Chairman Powell clarified after the communications debacle in December. The Fed has done a U-turn in its view of slack in the labor market and now sees an opportunity to engage those hardest hit by the crisis, and still stuck on the sidelines, by running the expansion a little hotter in the near term. Chicago Fed President Charlie Evans has been the most consistent in defining what he means by “hot,” or maintaining a symmetric inflation target. He has argued that the Fed’s official target should be allowed to average 2.25% for a period before the Fed moves to cool things.

The FOMC statement will leave the door open for another rate cut later this year in response to the headwinds emanating from protectionist policies and risks of spillover effects from the weakness we are seeing abroad. The statement is likely to disappoint on the timing of the Fed’s next move, dependent more on actual data than managing downside risks. The FOMC now believes that its best defense is offense when it comes to combating a recession with rates already so close to zero.

This could be another big news year for the Kansas City’s annual meeting in Jackson Hole, Wyoming, given the spectrum of risks that is mounting. A hard Brexit, or an exit by the UK with no customs agreement, which has already triggered a marked slowdown in the UK, is becoming more likely; the eurozone has failed to recover; and, trade wars are spreading. Vietnam will likely be hit with new tariffs for its role in helping producers escape tariffs levied on China. Separately, Japan is punishing South Korea over a diplomatic dispute.

The Federal Reserve is once again moving in tandem with other central banks. This could magnify the risk of asset price bubbles down the road. Central bank officials the world over are now worried about the surge in corporate debt and, to various degrees, emerging bubbles in real estate values, mostly in the commercial real estate market.

The elephant in the room is China. If the Chinese economy makes a hard landing, the aftershocks will be tough for any country to escape. Worse yet, the problems are structural rather than cyclical and will not disappear with an abrupt end to trade wars.

Bottom Line
The FOMC will cut rates in July for two reasons. The first is because it may have overshot and tightened too aggressively in 2018. The second will be to sustain an expansion that is slowing. FOMC members are attempting to offset damaging trade policy decisions that could hit us with a lag. The Fed does not want to be blamed for the next recession.

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