The U.S. Federal Reserve's (Fed's) first interest-rate cut in more than a decade may have been widely expected, but it's also more significant than it appears at first glance.
The majority of media coverage and market commentary we’ve seen so far has been focused on what the Fed did on Wednesday, that is, the quantum of the rate cut and the ensuing market reaction. In our view, the “what” was relatively straightforward:
- Interest rates were cut by 25 basis points (bps).
- The Fed’s balance sheet runoff known as quantitative tightening now ends as of August 1, two months earlier than planned. This makes sense: Why ease with one tool but tighten with another?
- The interest rate it pays banks to park their excess reserves at the central bank was cut by 25bps, from 2.35% to 2.10%.
However, we believe the why—the rationale behind the Fed’s decision—is far more important. Unfortunately, it’s also more difficult to discern. Officially, the Fed’s statement implies the decision to cut rates was fairly broad, attributing it to “the implications of global developments for the economic outlook as well as muted inflation pressures.”¹ However, during Wednesday’s press conference, Fed Chair Jerome Powell also continued to emphasize that the Fed’s base case for the economy is “a positive one,” which included expectations for a sustained economic expansion.
If that were the case, why cut interest rates at all?
We believe the Fed's substantially more focused on inflation and inflation expectations than its statement formally alludes to, and that its desire to boost price pressures is the primary driver behind Wednesday’s interest-rate cut—and for that matter, any forthcoming cuts.
Interest-rate cuts: a tale of three different narratives
Investors are likely to have come across two different broad sets of narratives explaining the Fed’s decision to embark on a rate-cutting path. The first, favored by a group of market watchers who belong to what we call the “easing cycle” camp, suggests this could mark the beginning of a more typical Fed easing cycle, which is similar to the majority of what we've experienced in the past three decades. On average, easing cycles tend to produce, on average, around 500bps of rate cuts² and are typically a reaction to an economy that’s already in, or is heading toward, a recession.
In the current environment, a traditional easing cycle would imply that the FOMC will take rates to 0% or below, and that the U.S. 10-year yield will also fall to zero, which will likely be accompanied by some pain for risk assets. Admittedly, after Wednesday’s surprisingly robust press conference, this narrative is likely to be relegated to the sidelines … at least for now.
The second narrative, advocated by those in the “insurance cuts” camp, suggests these cuts—which typically involves lowering rates by a total of 75bps in one or two increments—are intended to offset short-term cyclical weakness in U.S. growth, in this case, because of trade tensions and weak global manufacturing activity. The Fed has acted similarly (twice) in the 1990s: It most famously undertook this approach in 1995 and again in 1998.
Fed Chair Powell’s insistence during Wednesday’s press conference that the central bank's engineering a “mid-cycle adjustment” is far more consistent with the insurance cuts camp versus the easing cycle camp, and markets appear to be unwinding a good deal of their easing cycle pricing.
We believe the narrative needs further refining. In our view, the Fed could be engaging in an important variation of the insurance cut that it hasn’t done before, which we call the “reflation cut.” These cuts aren’t primarily designed to support short-term growth (although that’s a helpful offshoot, particularly in an environment defined by elevated uncertainty), or as a response to recession risk. Instead, they’re undertaken to produce a structural inflationary overshoot and to reignite persistently weak inflation expectations that have become de-anchored from 2%. If this is indeed the case, by explicitly attempting to engineer greater than 2% inflation, the FOMC will likely contribute to an overheating of the U.S. economy.
The most important difference between a typical insurance cut and our theory of reflation cuts is that central bank dovishness doesn’t end when growth reaccelerates; it only ends when inflation has persistently gone above 2%. This implies (a) the Fed’s likely to stay on hold once it’s done cutting for a prolonged period of time, longer than it would have done in an insurance cut environment, and (b) risk assets could benefit from both lower rates and stronger growth. Wednesday’s press conference is that it confirmed our belief that the Fed’s trying to ease its way into an economic stabilization (and potentially into a reacceleration).
Ultimately, regardless of which narrative we end up subscribing to, the broader story is clear: In our view, the Fed’s going to cut at least once more, probably in September, and the 2016/2018 hiking cycle is now over.
1 “Federal Reserve issues FOMC Statement,” federalreserve.gov, July 31, 2019. 2 Manulife Investment Management, as of July 31, 2019.