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A Case for a Pause in Rate Cuts

RFP
Financial markets widely expect the Federal Open Market Committee (FOMC) - the policy-setting arm of the Federal Reserve - to cut rates again at its meeting October 29-30 to insure that the weakness we are seeing in response to slower global growth and tariffs will not become more serious. My sense is that we still face a 60% chance that the Fed holds the line on rate cuts at its meeting next week. That could disappoint financial markets but could be managed by pledging to stay flexible on rate cuts going forward. Fed Chairman Jay Powell has been good at conveying this part of the Fed’s message.

Frankly, it is stunning that the Fed refused to commit to the outcome of the meeting ahead of time. They simply didn’t know what shoe might drop in the days leading up to the meeting, including the risk of a hard Brexit on October 31.

The outcome of Brexit is still an unknown and, at least for the moment, the administration has lowered the temperature in the trade war with China. Those shifts, combined with the noise created by the GM strike (which will magnify the losses we are seeing in manufacturing) provide an argument for the Fed to sit out this meeting. At least one key member of the committee, Charlie Evans of the Chicago Fed, has underscored that the Fed would need to move again if those risks materialize. However, he has moved more toward the sidelines than he was at the past two meetings when he voted for a rate cut.

This is at the same time that the two most vocal proponents of cuts - Presidents James Bullard and Neel Kashkari of the St. Louis and Minneapolis Feds, respectively - have tempered their calls for more aggressive rate cuts. Both now favor a quarter-point cut instead of the half-percent cut they pursued earlier in the year.

The fact that the Fed has already reversed half of the one percent hike in rates of 2018 is also important. We have yet to feel the full effects of those cuts on the economy, given the lag between changes in rates and their impact on the economy. Powell himself has characterized what we are seeing as a mid-cycle adjustment to rates, much like we saw in the late 1990s. The Fed cut three times in 1998 in an effort to stabilize financial markets and insulate the economy from the spillover of that meltdown. What most forget about the 1998 cuts is that many on the Fed were worried that the final cut was not necessary. The economy was already stabilizing by the time we got to November 1998 but the Fed cut again anyway. Former Fed Chairman Alan Greenspan wanted to make sure the financial market instability we had seen was behind us. In the process, cutting rates a third time in 1998 stoked an emerging technology bubble. This is something that those who oppose another cut now would like to avoid.

So where does that leave us? If the Fed cuts another quarter point, as markets expect on October 30, Presidents Eric Rosengren of Boston and Esther George of Kansas City are expected to dissent again. This time however those dissents will represent the views of at least six regional Fed presidents as opposed to four at the last two meetings. President Bullard is expected to remain silent this time if the Fed cuts, as that move would satisfy his desire for one additional cut this year; Kashkari does not currently vote. Two dissents may be read as bad news for future rate cuts and undermine the Fed’s desire to remain flexible.

Another benefit of not moving now would be that it would shore up perceptions of the Fed’s independence at a critical juncture. Market participants are starting to believe that the Fed is capitulating to pressure from the White House, despite efforts by the Fed to dispel those notions. A strategic pause on rate cuts could help derail those perceptions, even if it further infuriates the administration.


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