The Fed cuts its rate

The #Federal Reserve drops it’s rate by 25bp to 2.00-2.25%. Reasons are too low inflation rate and global uncertainty. It’s a kind of preemptive move which is quite weird. Usually the US central bank drops it’s rate when the environment is already bleak.

One reason for that comes from the fact that we don’t know the future, neither the Fed nor us. There is therefore a risk of credibility for the Fed if there is a rebound in the economic activity of a size that has no relation with the rate cut. The other risk is associated with political pressures from the White House. It’s also a source of concern.

Can we expect lower Fed’s rate in July ?

The possibility of a 50 basis point interest rate cut by the US Federal Reserve is on everyone’s lips. The dots chart published at the end of the June 19 meeting indicated that rates would remain at the current level in 2019, but it showed that 7 members suggested a 50 bp decrease in 2019 (stability is calculated on the median of the results).
That was all it took for observers to switch to a similarly sharp decline at the July 30-31 meeting. The explanations given are those of Donald Trump’s pressure on the central bank either through threats relayed on Twitter or by the members appointed by Trump to the FOMC.

Such an interpretation raises several questions
The first is that at the Fed, the president always has the last word. Jerome Powell’s recent comments do not give this sense of urgency about lowering rates. This implies that the July rate cut, if it were to take place, would be more than a palace revolution since its president would be outvoted.

The second point is that the macroeconomic data also do not reflect the urgency of a change in the central bank’s strategy.
To gauge the economic situation I used the CFNAI index calculated by the Chicago Fed. It includes 85 indicators of the federal economy (from industrial production to retail sales, employment and orders for durable goods). The calculated indicator is centered on 0, and a value below -0.7 (on the index on average over 3 months as shown in the graph) suggests a risk of recession.

Since 1985 (the beginning of the great moderation), I have then measured the changes in the pace of the Fed’s monetary policy. The first graph shows the fed fund rate and the points used to mark the shift towards an accommodative monetary policy.

The second graph shows the dates of monetary policy changes and the CFNAI index.
Since 1985, monetary policy changes have taken place when the CFNAI index is close to -0.7, i.e. when the risk of recession becomes clearer. The only exception is 2007 when the issue of liquidity on many financial structures was raised. This is a special case.
The current level of the index is not consistent with a decline in Fed rates unless we imagine a deep break in all US indicators for June and July. This is not our scenario.

This means that, in the absence of economic or financial justification, a reduction in the Fed’s rates and a defeat of its President would first reflect a collapse in the credibility of the US central bank due to its loss of independence. As the world’s most powerful financial institution, it is likely to cause significant turmoil in financial markets. Should we take this kind of risk? I don’t think so.

The Fed’s message in 8 points

The Federal Reserve message is clear:

1- Macro data remain robust and expected inflation is low

2-Risks on the economic prospects are on the upside

3 – The Fed will adjust its rate if necessary but nothing is on the agenda

4 – The dots’ graph doesn’t give information as it shows one drop in 2020 and one hike in 2021

5 – Powell introductory statement indicates a bias on the downside for the Fed’s rate in the future.

6 – Long term rates dropped on this perception even if nothing has been said on the agenda. The 10y is now below 2% and the 30y below the fed funds rate for the first time in this cycle

7 – In the past, when all rates are below the Fed’s rate it’s a signal of recession. The drop in the Fed’s rate will come but will not be sufficient to avoid a recession.

8 – The reason is that low long term interest rates reflect low expectations on the future. They can’t reverse spontaneously. Economic phenomena are persistent

The Fed is in no hurry to adjust its monetary policy

In its monetary policy statement, the Fed says there is no reason to lower interest rates rapidly. Activity data are still robust and inflation remains moderate. Therefore, as long as there is no sudden inflection, there is no reason for the central bank to rush to adjust its monetary policy. (This is what I mentioned here)

The dots’ graph, reflecting the FOMC members’ expectations, considers that the fed funds rate will be stable in 2019, decline once in 2020 before going back up again. in 2021 at the current level.

The US central bank, which does not want to hurry given the economic situation still strong, does not want to give signals on what it will do. This is the end of the Fed’s forward guidance. It does not commit to anything, thus confirming its desire not to tie hands with commitments that may not be in line with changing circumstances.

What to expect next week ? (June 17 – June 21, 2019)

Highlights

  • The main focus this week will be the Fed’s meeting. I don’t expect a announcement for a rapid drop in the Fed’s rate.
  • The Fed must show its independence when macro data are still robust while the inflation rate remains low.
  • The inversion of the yield curve will continue and I expect a drop in the Fed’s rate next fall as macro data will be weaker.
  • The US housing market is key in the short term dynamics. Existing home sales is a proxy for a wealth effect on this market. Its recent downside trend may be consistent with a slower consumption pace on consumers’ side
  • Flash estimates of the Markit survey will highlight the depth of the US slowdown in the manufacturing sector and the profile of New Export Orders which are consistent with the world trade momentum
  • The ZEW and the Markit survey for June in Germany will reflect the impact of the world trade slowdown. It has already been important on exports. More may be expected.

The document can be found here NextWeek-June17-June21-2019