As U.S. Federal Reserve officials enter the communications blackout period ahead of the June 18–19 FOMC (Federal Open Market Committee) meeting, bond markets are pricing in a modest chance (roughly 12%) that the Fed will cut interest rates by 25 basis points in June, and a much higher (roughly 88%) chance of a cut by the subsequent meeting in late July (source: Bloomberg as of 10 June 2019). We don’t expect a rate cut in June, but if downside risks to the economy escalate, a 50 basis point cut in July is possible, in our view.
Much has changed since just last month, when markets were generally pricing the Fed to be on hold in 2019. The Trump administration’s threatened tariffs on Mexican imports, though they were not implemented (at least not yet), along with escalation of tensions with China, have driven tremendous uncertainty in the U.S. economic outlook. This provides Fed officials with an opportunity to define preemptive monetary policy easing in practice.
Risks to the economy mounting
While our baseline outlook remains that the U.S. will avoid a recession at least over the next year or so, the renewed prospect for more economically disruptive trade and foreign policies, occurring while U.S. growth is already decelerating, greatly increases the risk of a more notable fall in economic growth or even an outright recession, in our view.
In the face of these downside risks, we are not surprised the bond market is pricing in Fed policy rate cuts. Although the central bank has some room to ease monetary policy in the event of a more pronounced downturn (the current fed funds rate is a range of 2.25%–2.5%), the zero or “effective” lower bound (ELB) is still an important constraint. Our view – which we believe a number of Fed policymakers share – is that this ELB constraint argues for a “stronger sooner” easing response when faced with greater downside risks to the outlook, even if a recession isn’t expected. If this more forceful approach ultimately reduces the chances of returning to the ELB, it appears to be the more prudent risk management strategy.
Baseline and risk scenarios
At the June FOMC meeting next week, we think that Fed officials will discuss the prospects for rate cuts, but not announce one. Chairman Jerome Powell is likely to reinforce the message from Vice Chair Richard Clarida, echoed by Governor Lael Brainard and Chicago Fed President Charles Evans, that the Fed will adjust policy – including cutting interest rates – as appropriate in response to changes in the outlook.
In a worst-case scenario, where tensions between the U.S. and China are not at least scaled down before or during the G-20 meeting in late June, the Fed could cut rates as early as the July meeting. We could potentially see a more aggressive 50 basis point move for maximum effect given how low rates are. If this risk scenario comes to pass, we wouldn’t expect Fed officials to wait for the economic data to confirm declining U.S. growth – if they do, they could risk a more meaningful shock to economic activity.
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Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.