Wednesday’s interest-rate cut represents a continuation of the global easing cycle. Our Chief Economist and Head of Macroeconomic Strategy Frances Donald takes a magnifying glass to the proceedings and identifies the key themes from the Fed’s communications and the problems that the central bank is facing.
- Fed Chair Jerome Powell is more dovish than the rest of the FOMC, but the hawkish members of the committee are slowing the Fed’s reaction to economic developments, which increases the likelihood of a policy mistake.
- A further rate cut in October is a reasonable base case, but this is contingent on trade policy developments (the markets are currently pricing a 43% chance of another rate cut in October).1
- The Fed is likely going to have to restart an organic balance sheet growth before year end.
Critically, we believe there could be more rate cuts in the next 12 months that markets have yet to fully price in. In other words, we expect the Fed will need to move more aggressively in the future in order to play catch-up—particularly as we see a growing list of issues confronting the U.S. economy.
Problem 1: the trade war is hurting the U.S. growth outlook more than most—including us—had initially expected
Geopolitical tensions might have eased in the past two weeks, but they remain substantially more elevated today than they were on July 31. Critically, U.S. companies are facing more tariffs than at July’s FOMC meeting. Moreover, the U.S. manufacturing outlook continues to deteriorate. The Federal Reserve Bank of New York’s estimate of Q3 GDP currently stands at around 1.6%, and it expects growth to slow to 1.1% in Q4.2 We agree with that assessment and believe that first-quarter growth next year could come in between 1.0% and 1.5%—hardly a stellar growth figure by any means.
Problem 2: geopolitical risks are amplified
Hong Kong protests, Brexit, Argentina, and the threat of a global oil supply disruption—recent headlines relating to these events suggest markets might have underpriced risk. Notably, barring the drone attack on oil refineries in Saudi Arabia, which has only just happened, tensions around these events have intensified since the last Fed meeting.
Problem 3: those pesky yield curves
Every major part of the U.S. Treasury’s yield curve has now tipped into inversion. Even if some segments of the yield curve have recently bounced back into positive territory (such as the 2 and 10 year),1 the elevated recession probabilities associated with the first inversion remain worrying. Moreover, the yield curve has now been inverted for longer than the periods during which it provided so-called false signals about an impending recession. While there are reasons to believe that the yield curve is distorted due to a compromised term premium, the Fed has historically misjudged the damage created by an inverted curve, and we don’t expect it to be comfortable with this level of inversion.
Problem 4: a strong U.S. dollar hurts growth
The Fed has been clear that it isn’t targeting the U.S. dollar (USD), but it’s safe to say that the central bank has incorporated the value of the trade-weighted dollar into its analysis for the following reasons. A strong USD:
- Is mechanically deflationary
- Hampers U.S. profits/business investment
- Represents a form of tightening of global financial conditions
The Fed’s past analysis has suggested that a 10% appreciation in the real trade-weighted dollar could cut U.S. GDP by 0.5 percentage points.3 With that in mind, we can’t help but notice that, on a trade-weighted basis, the greenback has gained 9% since the beginning of 2018.
Problem 5: inflation expectations are still struggling
Realized inflation has improved in the past three months: The three-month annualized core personal consumption expenditure (PCE) is nearing 2.0%.1 That should be good news, except that longer-term inflation expectations—the ones that drive the Fed’s forward-looking model—remain very weak. If the Fed wants the yield curve to steepen, it needs to convince markets that its actions will lead to higher inflation over time; a higher level of inflation at this juncture that’s accompanied by depressed long-term inflation expectations can only produce a flatter yield curve (and, more than likely, hurt central bank credibility).
Problem 6: stagflation risks are rising
Recent upside surprises in inflation might be thought of as positive news, but they’re occurring in an environment of weakening growth. An analysis of previous periods of stagflation shows that equities typically fare badly in an environment defined by slower growth and higher inflation— in other words, stagflation. In our view, stagflation is primarily a Q4 problem, with higher inflation in part being driven, in the short run at least, by tariffs that will drop out over time. Similarly, the subsequent demand-side shock associated with tariffs will also ultimately be deflationary over the medium term.
Given that the Fed has undershot its 2.0% inflation target for almost the entire duration of the current economic cycle, we expect it to prioritize growth concerns over inflation fears, at least for the time being. What this means: Hitting the inflation target should not, in our view, deter the Fed from introducing more interest-rate cuts.
Problem 7: job growth is decelerating
The United States added 130,000 jobs in August—a reasonable number by most accounts, but it’s clear that the momentum behind job growth is slowing. Some commentators view it as a reflection of having too few people in the labor market, as opposed to having too few jobs; in other words, they believe that we’re simply running out of people to hire. The problem with this narrative is that job openings are also decelerating. The stagnation of wage growth around the 3.2% level also suggests the slowdown is likely to be more related to a slowing demand for workers.
What’s not a problem: the U.S. consumer
There’s one shining light in the U.S. growth picture, and it continues to be the U.S. consumer: Consumer confidence is near historic highs, and retail sales have re-accelerated. Representing around two-thirds of the economy, it’s tempting to say a strong consumer will help us overcome all of the above problems—it’s an attractive idea, except that consumer spending is a lagging indicator and has consistently performed well shortly before recessions. While we aren’t calling for a recession, we’re inclined to put more weight on the issues we’ve listed so far than U.S. household spending for now. We hope the Fed will do the same.
1 Bloomberg, as of September 17, 2019.
2 “Nowcasting Report,” Federal Reserve Bank of New York, as of September 13, 2019.
3 “The Effect of the Strong Dollar on U.S. Growth,” Federal Reserve Bank of New York, July 17, 2015.