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Fed Update 9-18-2019

9/18/2019 scott

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Fed Note:

As expected, the Federal Reserve Open Market Committee lowered the fed funds rate a second time by 0.25%, to a new range of 1.75-2.00%. There were a few dissents, strangely in opposite directions, with one member wanting a larger 0.50% cut and two others voting for no cut.

The formal statement was minimally changed, upgrading the note that household spending has been rising at a strong pace, while business fixed investment and exports have weakened. However, the ‘dot plot’ showed no additional cuts through the end of next year—in fact, a quarter-percent higher than today.

Today’s decision had the potential of being muddled by several factors from the past several days, although neither was mentioned specifically: the Saudi attack-induced oil price spike, as well as a more obscure Fed intervention (of up to $75 billion) into the short-term repurchase market. In the ‘repo’ market, where entities (banks mainly) borrow and lend high-quality bonds (U.S. treasuries mainly) on a short-term basis, a lack of available cash pushed overnight rates up dramatically for a short time. This appeared to be the continuing result of excess reserve balances at the Fed falling, as bank investors have been moving assets back and forth between cash and newly-issued government bonds (of which supply is substantial). This appeared to be largely technical, although the nuances of the Fed’s various interest rate targeting mechanisms in recent years, including interest paid on excess reserves, have created a much deeper web of complexity, and raised chances of such liquidity shocks. In response, it’s possible the Fed may again expand its balance sheet to handle such clogs in the ‘plumbing.’

This policy action was entirely expected, based on not only on futures markets (which priced chances at 70%), but also communication by Fed governors over past weeks. The path of multiple rate cuts was accepted as a foregone conclusion. Now, will it be only two cuts or more like three or four? (December odds remain split between 1.50-1.75% and 1.75-2.00%.) The key mandates monitored by the Fed continue to show mixed results, which has exacerbated the discussion among economists about the necessity of this easing. The accepted dogma is that these are being done for ‘insurance reasons,’ as opposed to the traditional approach to easing in response to data deteriorating outright.


Economic growth: This has slowed from peaks in the shadow of the tax reform package, but remain generally in a range of around 2.0% at the low end, via several Federal Reserve district estimates, to an upper limit of just under 2.5%. Expectations for future quarters/years lie a bit below this, down to as low as 1.5%, but still not radically under the recent range or estimated ‘potential’ U.S. growth rate of about 1.75%. The potential impact from various worst-case scenarios of the U.S.-China trade spat (if all tariffs were imposed) have proven difficult to measure completely, due to the various linkages, but could range somewhere from -0.5% to -1.0% in the near term. Considering current low levels of GDP, this could be substantial for a time. While a shock to the system, the recent Saudi oil facility attack may cut 0.1-0.2% from consumption growth if a $10/barrel price spike persists, based on historical precedent, but fears have already calmed down a bit. Longer-term, however, the continued impulses of low labor force growth and mixed productivity continue to weigh on potential broader economic growth, potentially restraining it within the current range.

Inflation: Little has changed on this front, with most recent CPI coming in at 1.8% for headline and 2.4% for core on a year-over-year basis. The Fed has pointed to low recent inflation levels, and fears of consumers eventually expecting disinflation, as a partial rationale for the current monetary easing stance. Around the same time the Fed made the comments, there appeared signs of inflation picking up a bit, but not by extraordinary amounts, with most of the upward pressure originating from medical care services and housing/shelter costs. Longer-term, there appear mixed forces at play, such as the impact of technology, which could cause the battle between rising and falling prices to persist.

Employment: This has been an area of continued strength, although the pace of growth has moderated. This is the clincher when it comes to labor markets—when a maximum number of workers are employed, rarely can conditions continue to improve radically, but they often eventually deteriorate. At the same time, though, they can remain stable at a high level for an extended of time before this occurs. Depending on when the next recession comes, labor has only been held back by lack of available workers in certain industries (like construction) and wage growth (which has started to pick up). So far, though, conditions would continue to justify rate hikes or inaction, as opposed to easier policy.


Asset markets have been expecting this outcome, and many continue to question whether the newly easy monetary policy is warranted, or if there are deeper chasms not yet visible the Fed is preparing for. Despite sentiment seeming to be increasingly skeptical about a U.S.-China trade outcome before the 2020 election, financial markets continue to rise and fall weekly based on prospects for a grand summit, or tariff delays at the very least, which could be more growth-friendly to the global economy compared to full tariff implementation. From a longer-term basis, waiting for interest rates to ‘normalize’ higher has been a common theme in financial markets, with the rationale that treasury rate ‘fair values’ should be higher than they are; yet, this has been more than offset by slower growth dynamics, lack of inflation, and high demand for safe assets. The end of that type of regime has historically proven difficult to predict.

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