The Federal Reserve’s decision on 31 July to lower the target range for the federal funds rate by 25 basis points (bps) to 2.0%–2.25% marks the first policy rate cut in more than a decade. It had been well telegraphed, and was widely expected by us and by markets. Also as expected, the Fed’s statement left the door open to further rate cuts by noting that risks to the U.S. outlook remain.
Less expected was Fed Chairman Jerome Powell’s lack of emphasis on forward guidance during the post-meeting press conference. Indeed, Powell shied away from providing any specific guidance on the likely economic conditions that would warrant further easing. The 400-point drop in the Dow Jones Industrial Average as Powell spoke demonstrated the market’s surprise.
However, we find the Fed’s statement clear: The Fed will continue to watch economic developments and “act as appropriate to sustain the expansion.” We expect another rate cut as soon as September with possible additional cuts thereafter. Growth in U.S. manufacturing, investment, and exports is likely to fall further over the next several months, and the Trump administration’s latest announcement to impose additional tariffs on China is likely to only exacerbate the weakness.
We think the chairman’s hesitation about communicating the future rate path likely reflected the fact that the Federal Open Market Committee (FOMC) members are divided in their views. Two FOMC members dissented from yesterday’s decision to cut rates. And based on FOMC members’ rate projections in June, about half the committee thought no rate cuts would be needed this year, while others were forecasting 50 bps in cuts. The Fed’s final decision to cut by 25 bps was most likely a compromise, but we suspect that economic developments between now and September will ultimately garner a greater consensus to ease more.
‘Insurance’ rate cuts
Ten years into the U.S. economic expansion, we still do not think a recession is imminent. The household sector is in good economic health, and the recent easing in financial conditions will buffer the U.S. economy from a larger downturn.
Consequently, we see the Fed’s move as an “insurance” cut designed to keep the U.S. expansion on track amid some recent signs of weakness. As revised GDP data from 2014-2019 show, the U.S. is not immune to global economic developments, and we think the Fed is looking to avoid any tightening in financial conditions that could result. Signs of a softer economy can lead to a loss in confidence by markets and businesses, which can in turn cause banks to reduce lending quickly, ultimately creating tighter financial conditions that further derail activity – a slide toward recession through the so-called “financial conditions accelerator channel.”
In our view, the Fed’s rate cut is an effort to manage this risk, and it appears to have worked. Over the past few months, the Fed has taken a more dovish stance and provided forward guidance toward a rate cut, which has contributed to easier financial conditions. We see the potential for at least one more “insurance” rate cut from the Fed to ward off the risk of substantial economic softening.
Low inflation is key
Although lifting inflation is not the main motivation, low inflation has made the Fed’s easing possible. Inflation in the U.S. has remained near or below 2%, and this lack of threat to price stability should allow the Fed to continue to focus on sustaining economic growth in an effort to achieve its other official mandate: maximum employment.
Financial stability risks also appear manageable. Over time, it is possible that lower rates could increase the risk of financial instability by leading to market excesses – including rapid loan growth and asset bubbles – a topic recently discussed by Fed Governor Randy Quarles. But amid higher uncertainty and lower business confidence, midcycle “insurance” rate cuts seem unlikely to unleash the type of irrational exuberance that could cause a destabilizing bubble. And in fact, we think they should help stabilize the economy going into 2020.
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Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.