Fed Looking Set To Cut Again

If You Don’t Have Any Time This Morning

The Fed is leaning toward a rate cut next week. I suspect that they will need to be a little more direct about the conditions that will drive future policy moves; a statement like the last will fuel the perception that another rate cut is in the works for December.

Technical Updates

I have been a bit radio silent this past month, still working through some technical issues with my subscription service. I will be moving some subscribers over to MailChimp soon. Sorry for any inconvenience this down time may have caused.

Key Data

The data flow remains fairly lukewarm, neither demanding another rate cut nor requiring the Fed to hold rates steady. Manufacturing remains the weakest link in the chain. Industrial production dipped 0.4% in September but the GM strike was an extra drag on the data. Excluding autos, industrial production was down just 0.2%. Note that after declining in both the first and second quarters, industrial production posted an annual rate of 1.2% growth in the third quarter. This could signal that the downtrend in manufacturing is bottoming out. Watch the PMI’sgoing forward for signs the numbers are stabilizing around the 50 mark. Some evident stabilization in manufacturing would pull the Fed away from a cut in December (assuming an October hike).

Retail sales came in on the soft side.I am wary about reading anything too negative into the numbers; the volatility over the last year has been unusual, with excessive weakness at the end of 2018, an offsetting jump early in 2019, and a string of unusually consistent solid readings over much of this year. Washing it all out puts the year-over-year pace at a respectable 4.9%, closer to the highs than the lows of this cycle.Note that the Michigan consumer sentiment measure (preliminary) rebounded in October, suggesting that household spending continues to hold up more broadly.I don’t think interesting things are going to happen in consumer spending as long as the labor market remains solid. And while job growth looks to have slowed since last year, initial jobless claims continue to hold at fairly low levels. The dispersion of worsening claims is a bit wider but not so much that they would signal firms will soon engage in widespread layoffs.

Housing starts declined in September although previous months were revised upwards. The volatile multi-family component accounted for the decline; single-family units have for all intents and purposes rebounded from last year’s swoon. Monetary policy worked as expected in housing, with lower rates stimulating a market that began to look shaky. Also note the builder confidence rebounded in line with housing.Inflation expectations are looking weak with a noticeable downtrend in the New York Fed measure and a record low for long-term expectations of 2.2% in the Michigan estimate. Needless to say, this is not the data the Fed is looking for. The Fed very much needs to keep the economy out of recession if they hope to reverse these trends and stabilize inflation near their 2% target.

Fedspeak

We continue to see mixed opinions on the need for another rate cut in October.There is a contingent that includes Boston Federal Reserve President Eric Rosengren and Kansas City Federal Reserve President Esther George that oppose another cut; both will likely dissent again if the Fed cuts as expected. There is another contingent that is leaning in the direction of holding steady but could likely be convinced to accept another cut. For instance, Dallas Federal Reserve President Robert Kaplan falls in that category. From Nick Timiraos at the Wall Street Journal:

Mr. Kaplan told reporters Friday he had strongly supported the prior two rate cuts well before each meeting but that he was now agnostic about whether the Fed should proceed with a third rate cut in October. “We have a December meeting also,” he said.

“One argument to me is to take a little bit more time, reserve the right to take additional action if conditions merit it,” he said. “It may be wise to take a little time to assess and continue to turn over a few more cards. That’s what I’m weighing.”

The argument here is that the economy is not obviously desperate for a rate cut and therefore the Fed has time to assess whether another cut is actually necessary. Even if you anticipate the need for another rate cut this year, they still have December left to make that move.

Minneapolis Federal Reserve President Neel Kashkari supports another rate cut, but has backed away from calls for a 50bp cut. Via Mike Derby at the Wall Street Journal:

Mr. Kashkari explained that he isn’t pressing for a half percentage point cut now because conditions have changed. When he made that argument, doing a big rate cut then would offered a salutary jolt to the economy. “We’ve somewhat lost the shock opportunity,” he said.

I disagree with Kashkari on this point; moving 50bp when completely unsuspected would have some serious shock value next week. Still, it isn’t going to happen.

There is a large contingent on the Fed, particular the Governors themselves, that have not tipped their hands as to their expectation for this next meeting. Vice Chair Richard Clarida, for example, spoke last week on the economyand repeated the Fed’s mantra that the economy is “in a good place.” Still, I think this is notable:

But despite this favorable baseline outlook, the U.S. economy confronts some evident risks in this the 11th year of economic expansion. Business fixed investment has slowed notably since last year, exports are contracting on a year-over-year basis, and indicators of manufacturing activity are weakening. Global growth estimates continue to be marked down, and global disinflationary pressures cloud the outlook for U.S. inflation.

Clarida says that global growth estimates “continue” to be marked down. I think he would be more comfortable holding rates steady if growth estimates were instead steady. Later, when explaining why the Fed cut rates, Clarida says:

The Committee took these actions to provide a somewhat more accommodative policy in response to muted inflation pressures and the risks to the outlook I mentioned earlier.

Policy is only “somewhat more accommodative.” That suggests that there is room to go before policy becomes sufficiently accommodative to offset the downside risks to the outlook.

Thinking about the current low inflation environment, Chicago Federal Reserve President Charles Evans said:

This leads me to think that the Fed should continue to cautiously probe for the true level of maximum employment. That is, we shouldn’t treat a statistical estimate of the natural rate as a hard barrier that automatically signals an impending problem. Of course, we should also be mindful of the possibility that unwelcome inflationary imbalances could yet emerge. We need to keep both possibilities in mind.

This is something to keep in mind. Even if Evans isn’t jumping on the bandwagon for another rate cut, he doesn’t sound like he is looking for a rapid reversal of the recent cuts absent some evidence that inflation pressures are building. I think that the Fed will be more cautious in the future regarding rate hikes than they were in 2017 and 2018.

Upcoming Data

Fairly light week ahead. Backout period, so no Fed speakers. Existing homes sales on Tuesday and new home sales on Thursday will provide fresh looks on the health of the housing market; I don’t expect there will be any substantial changes in that part of the economy for the time being. Thursday we also see the usual initial unemployment claims report and the final release of Michigan consumer sentiment will come on Friday. Perhaps most important will be the readings on manufacturing. We get Richmond and Kansas City surveys on Tuesday and Thursday, respectively, and new durable goods orders on Thursday. So far, new core durable goods orders have held up well in this cycle, suggesting manufacturing weakness is actually fairly limited relative to the 2015-16 downturn in that sector.

Discussion

Despite generally lukewarm or outright hostility to the idea of another rate cut in the public musings of Fed officials, market participants anticipate with virtual certainty that the Fed will cut rates next week. There is good reason for this certainty: Senior leadership at the Fed has not actively pushed back on market expectations of a rate cut.

I don’t think this means the Fed is being bullied into another rate hike. I think more likely is that the core voting members of the FOMC are leaning toward a rate cut and hence see no reason to push back on market expectations. Why lean toward a rate cut? I see a number of reasons:

  1. Falling inflation expectations.The Fed has been fairly clear that they would view falling inflation expectations as an impediment to reaching their inflation target. Better then to err on the side of more dovish policy to help firm those expectations.
  2. Strong dollar.The strong dollar feeds back into the US as lower inflation. The Fed should want to push back against this trend with easier policy.
  3. Deteriorating global outlook.As Clarida noted, the global growth forecasts continue to fall. The Fed will fear that continued weak global activity will negatively impact the U.S. economy, particularly manufacturing.
  4. Balance of risks.Although there is arguably some light at the end of the tunnel in the trade disputes with China, the Trump administration has proved too many times in the past that tariffs remain a weapon to be deployed indiscriminately. The Fed cannot take any respite in the trade wars as anything but temporary.

In addition, I think the Fed will want to sustain the momentum provided by past rate cuts. Chair Jerome Powell has repeatedly stated that the Fed’s pivot to a dovish stance has been instrumental in holding up U.S. growth this year. This has been particularly evident in the housing sector. The Fed does not want to give up those gains, and hence should be wary of blindsiding markets by not cutting rates. Such an action would risk another major reassessment of the path of Fed policy, this time in a hawkish direction. That would not serve the Fed any purpose at this point.

Consider also the Fed’s signaling in recent months: Inflation currently is not a barrier to easier policy, falling inflation expectations would pose a challenge to meeting the Fed’s goals, low unemployment provides many benefits that would want to protect by holding unemployment low, and the risks to the downside still dominate the outlook. Unless the data is demanding otherwise, which it is not, the course of action that is most consistent with this signaling is another rate cut that errs on the side of caution.

The core of the Fed will want to get financial conditions sufficiently low that they are confident the economy can overcome the current basket of risks. That argues for another cut next week. Still, the cuts won’t go on forever absent a recession. I think they will have to eventually signal confidence in the stance of policy relative to the risks such that further rate cuts are not necessary without a clear deterioration in the outlook. I see that as a possibility for next week’s statement. In other words, we should be wary of a “hawkish cut.”

Bottom Line: The Fed is on track for another rate cut next week; the core of the FOMC has not been willing to push back on market expectations for a cut, so we can reasonably believe that market participants are correction understanding the Fed’s reaction function. At some point soon the Fed will start signaling that they need more justification in the data to keep cutting.

Trade ‘Mini-Deal’ Doesn’t Let Fed Off the Hook

A trade deal with China is in the works, potentially alleviating one source of stress on the U.S. economy. Still, the Federal Reserve can’t rest easy. The ongoing dispute has shattered investment confidence among business leaders, and one “mini-deal” won’t magically reverse their sense of uncertainty. Lacking an inflation threat to hold them steady, the Fed will likely continue to err on the side of safety with another rate cut at the end of the month.

Continued at Bloomberg Opinion….

For the Fed, Unemployment Is a Lagging Indicator

Odds have swung heavily in favor that the Federal Reserve will cut interest rates again at the end of this month even with Friday’s news that the U.S. unemployment rate dropped to a 50-year low of 3.5% last month. Central bankers are focused on the risks to future outcomes and will tend to pay less attention to lagging indicators such as the unemployment rate as they consider their next move. Thinking more broadly, the data overall is not showing enough strength to justify a holding rates steady.

Continued at Bloomberg Opinion….

The Case For A Rate Cut Could Be Solidified By Friday

Although we have only a few data points in hand, the odds are swinging solidly toward another Fed rate cut at the end of this month. If tomorrow’s employment report reveals an ongoing loss of momentum in the U.S. labor market, a rate cut will be locked in.

Given fairly resilient U.S. data and a divided Fed at the September FOMC meeting, I believed the Fed was positioned to hold rates steady in October with the risks tilted toward a rate cut. That view assumed continued data resilience. The data, however, is not cooperating.

Notably, the stress in manufacturing apparently intensified in September. The latest report from the Institute of Supply Management revealed that the global downturn weighed heavily on the sector; the new export orders measure fell further and now sits deeply in a range associated with past recessions.

To be sure, the manufacturing sector is now a fairly small part of the economy, nor is it clear that an external shock can trigger a U.S. recession. Consider, for example, that a U.S. recession did not follow the shock from the Asian Financial Crisis that also hit U.S. manufacturing. This example suggests that fears of U.S. recession might be overblown. The Fed may think similarly and conclude that recession risk it low, but the data and risks are evolving in such a way as to make this an increasingly risky bet.

Haven’t they already adjusted policy to compensate for the risks of slower global growth? Remember that the threats are not entirely external and that the risks are arguably now intensifying again. Trade policy disputes – entirely attributable to President Trump – weigh on manufacturing. And now the drama surrounding the impeachment process also creates additional uncertainty that threatens to further stall business investment.

The actual and ongoing damage to U.S. manufacturing from the global slowdown evident in the ISM report by itself argues for easier policy. Ongoing trade uncertainty combined with additional risk to the economy as the nation turns its focus on the impeachment battles further bolsters that argument.

While today’s ISM service sector report may provide additional reason for another rate cut, a weak employment report would certainty cement the case for easier policy.The labor market has been losing momentum for months and this week’s estimate of private job growth from ADP shows no reversal of that trend. My estimate of September job growth is a moderate pace of 123k, bolstered in part by Census hiring:Although job growth at that level remains sufficient to hold the unemployment rate roughly steady, the Fed can’t yet be confident that job growth won’t continue to slow enough in the months ahead and put upward pressure on unemployment. This is pretty much the last thing they want to see with inflation still low.

Bottom Line: To prevent another rate cut, the Fed needs a reason to believe that they have eased enough to offset the forces weighing down the US economy. It is difficult to see that they can reach such a conclusion without an improvement in the data flow. It is almost impossible how they can reach this conclusion now that it appears the negative forces on the economy are intensifying. By only the first week of October, the stage will likely be set for a third rate cut at the end of the month.

Manufacturing Slump Continues

October began on a weak note with a fresh drop in the ISM manufacturing report. It remains at levels that foreshadowed past recessions while those same levels have also been false alarms:

The mid-90s are notable examples of false alarms. The period around the Asian Financial Crisis is particularly interesting given the sharp drop in the new export orders that occurred in the absence of a U.S. recession:

The export orders index, which reflects external conditions, slipped past the 1998 low, indicative of the current severe slump in global activity. The current slump in the import orders index, which is more reflective of internal conditions, is more severe than during the Asian Financial Crisis. This pattern makes sense to me as there exist two factors weighing on U.S. manufacturing. The first and likely dominant force is the global slump. The second force is the deleterious impact of U.S. trade policy. The latter is obviously a self-inflicted wound.

From the Fed’s perspective, the data suggests that the risks to the outlook are increasingly realized in weaker data. As the Fed was positioned to cut rates further if the data continued to weaken, today’s ISM report argues in favor of an October rate cut. CME odds moved accordingly as the chance of a rate cut rose to 65%, up from 40% on the last day of September.

Still, 65% is not nearly a sure thing. The lack of commitment is understand given that we have a busy week of data still ahead with Friday’s employment report of particular interest. It also likely reflects some lingering concern about a possible revolt against another rate cut by the hawkish contingent of FOMC participants. The latter is effectively a non-issue; the core of the FOMC voters is inclined to cut rates if the data does anything but improve. That meant there was a better than 50% chance of a rate cut regardless of any griping by the hawks. And, realistically, if the employment report reveals further downward momentum in job growth, a rate cut in October is pretty much a lock.

Bottom Line: October begins on a weak note, strengthening the case for a rate cut at the end of the month. Still much data ahead, but it needs to on net show improvement to keep the Fed from cutting again. Those ISM false alarms in the 1990s were likely false because, like now, the Fed cut rates proactively. It remains to be seen if the Fed can pull off that trick a third time. The fact that housing responded quickly to lower interest rates suggests that they can.

Housing Isn’t Signaling Recession

Federal Reserve Chair Jerome Powell and his colleagues often note the their dovish policy pivot this has been instrumental in supporting an economy subjected to numerous uncertainty shocks. The positive response of the housing market to lower interest rates supports that claim. New single family home sales came in ahead of expectations in August; the trend fairly clearly indicates that the sector has recovered from last year’s soft spot:

The housing sector is of course famously known as a leading indicator for the U.S. economy and hence the sector’s rebound would appear to indicate that recession fears are overblown. That said, remember that the 2001 recession had only a small housing component.  Just as manufacturing doesn’t seem to have the same connection to the overall economy as it did in the past, the same may be true for housing.

Separately, Federal Reserve leaders continue to struggle with their next policy move. Minneapolis Federal Reserve President Neel Kashkari thinks the Fed needs to get more aggressive. In an interview with The Washington Post, he argued that the Fed has placed the U.S. economy in a “dangerous position” with the 2015-2018 rate hike campaign that left growth vulnerable to negative shocks. Kashkari can “easily see justifying” rates being 50bp lower then now. Kashkari’s dovishness does not disappoint.

In contrast, Chicago Federal Reserve President Charles Evans, a voting member, implied that he was not looking for another rate cut just yet. Via Reuters:

“I think we are in a good place in terms of the rate setting,” Evans said. “We have adjusted in a much more accommodative fashion.”

Evans identifying himself as holding a “steady course” dot makes it more likely that the core of the FOMC voting members remain’s biased toward an additional rate cut between now and the end of the year. The next meeting is something of a toss up still with markets now setting 50-50 odds of a rate cut. The lack of a clear direction reflects uncertainty about how the Fed will view incoming data and news. Either the data needs to worsen to justify a cut or the data needs to improve to stop the core group of FOMC voters from pushing forward with another cut. Steady data is an unknown but odds favor a cut in that circumstance.

The housing data counts as a sign of improvement, but given the Fed’s focus on investment spending, I would anticipate them to be more responsive to further signs of weakness from the business sector than signs of strength from housing. Under this theory, this week’s most important release is Friday’s manufacturing orders report. Core new orders have held up well to date:

If that data reveals signs of substantial weakening, the conviction of the “we need another cut” camp will grow and the market odds should shift in that direction as well.

Bottom Line: With two rate cuts in the bag, the Fed is placing some extra emphasis in the data rather than the risks. The data could swing the October decision either way, though worth noting that a FOMC participant could both expect the Fed to cut rates again this year and pass on the October meeting. They can always follow up in December. 

Waiting On Data

I am a bit rushed for time this morning (this is a busy week traveling up and down I5 with events and speaking engagements in Albany, Salem, and Portland). Still, I wanted to take a minute to highlight some themes this week.

The central policy theme will be tracking data and risks to the forecast for insight into the Fed’s next move. Last week, the FOMC cut rates 25bp and left the door open for further cuts. In the post-meeting Pres conference, Powell was carefully not to give many hints on whether or not that meant another cut in October. Given the wide range of rate forecasts revealed in the Summary of Economic Projections, the next move is not obvious. Consequently, Powell emphasized the data dependent nature of the Fed’s decision making process.

My take – available via Bloomberg – was that the last two rate cuts were relatively easy calls for the Fed. The next move, however, is less obvious given that the data flow is holding up better than expected. The Fed remains caught between wanting to ease and stay ahead of any impending risks to the expansion while avoiding excessive easing that threatens to overheat the economy or create financial stability risks.  Fedspeak last week put the two viewpoints on display; see the Wall Street Journal here. Given the current firming in the data flow, it is reasonable to expect the Fed will hold in October with a risk that they ease. This scenario seems to fit with the current CME odds of a 55% chance of a 25bp cut.

Still, it is easy to tell a story that data and events evolve in such a way as to push the Fed toward another rate cut. Recent firming of the data may prove to be ephemeral, global growth isn’t looking too healthy, and trade remains a wildcard as do other geopolitical events such as Iran. Hence why the risks fall in that direction.

One important point: Although Powell appears noncommittal about the next move and I don’t think we really no what he is thinking, there may be a tendency for market participants to fall into the trap that he either doesn’t have control over the FOMC or that the lack of consensus among policy makers limits his choice set. I don’t think either is true. I think Powell enjoys support of the Board members, can easily bring on a couple presidents to his position, and that he doesn’t care if there is a consensus as long as he is getting the policy right. In other words, I think Powell can get what he wants, so don’t underestimate his willingness to move as he sees fit. He doesn’t need to build a consensus.

In other news, last week’s repo excitement appears to have settled down. There was a ridiculous amount of very bad and sensationalistic analysis floating around the web. This for example:

We all know you don’t total up repo operations as they are by definition temporary and reversed, right?  The “bailout” theme is pervasive last week:

Nope, not a bailout, and supporting these markets is one of the Fed’s jobs. It’s how they manage short-term policy rates.

The basic story is that even though the Fed knew they could run up against scarce reserves, they were still caught off-guard, and their slow response gave the impression that maybe something was wrong. There wasn’t and they were able to address the situation by returning to the pre-crisis central banking. Over the longer run, they will look for a longer term fix such as a standing repo facility or fresh POMOs to expand the balance sheet. In short, this isn’t the crisis you were looking for.

Bottom Line: Wait and see.

What The Fed Did Right And What The Fed Did Wrong

I am seeing some questionable commentary. Like this via Bloomberg:

Relying on repo operations doesn’t resolve the issue of reserves declining as the Treasury rebuilds balances, Hornbach wrote in a note. Having regular operations will also increase market uncertainty as the Fed could halt purchases at any time, while the size of its buying will have to expand over time as reserves drop, he said.

Seriously? The Fed isn’t going to randomly halt the repo operations. And yes, they are going to keep increasing the size of the purchases if needed. And if the shortage continues, the Fed is going to boost reserves via permanent open market operations, the dull as dirt balance sheet expansions that happened like clockwork prior to the crisis. Similarly, also this via Bloomberg:

“The next 11 days are going to be a disaster,” Simons said. “If you stack up on both sides the arguments for repo going higher again, it’s all of these things that drain cash out of the market that are persistent issues or unknown but could be persistent. Where are the arguments for repo going lower?”

The arguments for repo rates going lower are 1.) that the Fed just cut the federal funds target by 25 basis points and the IOER rate by 30 basis points, 2.) the Fed can pump as much money as they need to into the markets via repo operations, and 3.) the Fed can expand the balance sheet if they need to.

The Fed is doing the right thing here, using the tools they designed for exactly this purpose. For the most part this is old school central banking. People need to stop living in the last crisis.

That doesn’t mean the Fed is without fault here. Part of the reason for this confusion is that the New York Fed wasn’t on top of this on the morning of day one. The delay made it look like this was some kind of emergency rather than standard operating procedures. Why was the New York Fed slow in responding to evolving market conditions? That’s the story here!

Maybe, just maybe, the slow reaction is the result of eliminating the institutional knowledge. Recall that New York Fed President John Williams shook up his staff earlier in the year. Via Bloomberg:

The sudden departure of two longtime officials shook staff, sank morale and drew attention to the leadership of the New York Fed under John Williams as he enters his second year at the helm. On Wall Street, questions arose again a couple of weeks ago when a speech he gave inadvertently whipsawed markets.

The story involves Simon Potter, who ran the all-important markets desk, and Richard Dzina, head of the financial services group. Both were abruptly relieved of their roles in late May by Williams. Little explanation was given, but according to current and former New York Fed employees, as well as those close to the bank, the nature of the exits, by fault or design, seemed to be a warning: fall in line

The New York Fed plays a powerful role. It is the central bank’s eyes and ears on Wall Street. And as the only regional bank with a permanent vote on rate decisions, it has outsize influence in the financial system. The selection of Williams, a widely respected and oft-cited monetary economist who ran the San Francisco Fed for seven years, for the top job in New York raised eyebrows from the outset. A finance-industry background has traditionally been seen as a key qualification, something he lacked.

Williams, who during his San Francisco Fed days often mentioned his reluctance to pay too much attention to short-term swings in the markets, came under fire on July 18 after saying in a speech that central banks should act quickly “at the first sign of economic distress.”

Yes, well maybe those short term swings in some markets are important. IMHO, financial journalists are chasing the wrong story here. It isn’t that the New York Fed is doing their job with the repo operations. It’s why they weren’t doing their job earlier.

While we are the topic of criticizing the Fed, I am hearing a lot of commentary complaining that Federal Reserve Chair Jerome Powell isn’t in control of the Fed. The supposed evidence is the three dissents at the last meeting which signals a lack of consensus.

Consensus is overrated. I suspect that Powell feels the same way. Responding to a question from the Wall Street Journal Nick Timiraos, Powell said:

Well, let me just say, on the general point of diverse perspectives, you’re right, sometimes, and there’ve been many of those times in my now almost eight years at the Fed, many times when the direction is relatively clear and it’s relatively easy to reach anonymity. This is a time of difficult judgments, and as you can see, disparate perspectives. And I really do think that’s nothing but healthy. And so, I see a benefit in having those diverse perspectives, really.

I don’t think Powell is worried about generating a consensus. And I don’t think he should be worried. Think about the current situation. We clearly know whose opinion isn’t gaining traction, and hence whose opinion we don’t have to spend a lot of time fretting over. And we also know that the FOMC isn’t setting policy to make those people happy, or twisting the policy statement to get their vote. No one is tossing them a bone to get them to come on board with the consensus. This isn’t a bad thing. We are probably getting cleaner policy because it doesn’t have to be the typical product of a committee, something that is fundamentally designed to make everyone on the committee happy.

Also hearing commentary that Powell isn’t a good communicator, and not just from President Trump. So on this point, sure, Powell’s conversational, off-the-cuff style hasn’t always been the best for the job. We, including myself, will tend to read too much into errant remarks, largely because we all worry that we are on the wrong side of the call and no one likes to be on the wrong side of the call. That said, I think a fair comparison of this week’s press conference with the last reveals that Powell is modifying his approach. This week he appeared to anticipate questions much better than in the past and not start some story like “mid-cycle adjustment” that forced him to back up over himself and then turn back around. It was a clean, solid performance.

The only question that I thought received a less-than-satisfactory answer was that by the Washington Post’s Heather Long:

Hi, Heather long from the Washington Post. Mr. Chairman, in your view, is there any risk to the United States having much higher interest rates than Europe, and Japan, and other parts of the world? Is there any risk to the U.S. Economy to that divergence or any risks to the global economy?

The dollar is a critical element of the global financial system. My instinct is that the Fed can not set rates higher than the rest of the world without stressing the entire system. I think the Fed needs to think about this more, at least that was my response to Powell’s answer.

Bottom Line: There’s valid criticism of the Fed, and there’s invalid criticism. I worry that the apparent dominance of latter drives overly bearish conclusions.

The Case for More Fed Rate Cuts Is No Longer Strong

Note: Last week, the subscriber service was shutdown for this blog due to technical difficulties. We should be up and running again now.

My recap of yesterday’s FOMC meeting is up on Bloomberg this morning:

The Federal Reserve has now lowered its target interest rate for overnight loans between banks twice since the end of July. The central bank’s economic projections and Chairman Jerome Powell’s post-meeting news conference suggest policy makers aren’t quite ready to cut rates a third time, and will need to see either weaker economic data or an intensification of the U.S-China trade war to deliver that cut….

Continued at Bloomberg Opinion…

Gearing Up For A Rate Cut

Newsletter version!

If You Don’t Have Any Time This Morning

The Fed will cut rates 25bp next week and leave the door open for more. It is reasonable to argue that they need to cut 50bp. If that’s what they should do but won’t, adjust your forecasts down accordingly.

Key Data

The employment report for August 2019 revealed a slowing albeit arguably solid labor market in the U.S.Nonfarm payrolls grew by a somewhat softer than expected 130k, but that number was inflated by the addition of 25k temporary Census workers. Both June and July experienced modest downward revisions. Including Census workers, job gains are running at a 156k average monthly pace over the past three months. Importantly, the pace of gains remains above that which the Fed believes is consistent with steady unemployment. Still, the unemployment rate has been in the 3.6-3.7% range for five months now.

Wage growth surprised on the upside with a 4.8% annualized gain in August; the overall trend is 3.0-3.5% annual wage growth. Hours worked edged up and temporary employment made a solid gain for the month but the overall trend is a weak 1.7k monthly gain on average over the past year. Prime age labor force participation jumped back up; overall participation has basically flatlined since 2016.

One take on the numbers is fairly positive. The economy continues to generate jobs at a pace sufficient to either lower unemployment further or encourage more people to enter the labor force. The jump in wage growth might even suggest that the economy is finally bumping up against full capacity and that is the primary culprit behind slower job growth. And maybe the August jobs number is revised up. Another take is less positive.The job market has clearly slowed, and, after accounting for the Census hires, may have slowed very close to the point where unemployment at best holds steady. That significant downshift in momentum is very worrisome. The second derivative here is not our friend. Moreover, don’t take too much comfort in the stronger wage numbers as that can easily be a lagging variable; wages might not take a hit until unemployment starts rising.

See here for comments on manufacturingfrom last week. Note that GDP tracking measures from the New York and Atlanta Federal Reserve Banks are both at a below trend 1.5% for the third quarter. New York is looking at 1.1% growth for the fourth quarter. Most definitely nothing to write home about.

Fedspeak

Split opinions on the next policy move from policy makers. St. Louis Federal Reserve President James Bullard now wants the Fed to listen to market participants and deliver a 50bp cut at next week’s meeting while his colleague Boston Federal Reserve President Eric Rosengren thinks the risks to the forecast need to become reality before further rate cuts are justified. New York Federal Reserve President John Williams argues“[t]he economy is in a good place, but not without risk and uncertainty.” Importantly, he adds this:

An additional fly in the ointment, if you will, is the recently released downward revision for GDP growth covering last year and an announced estimate of a sizable downward revision to payroll employment. One implication of these revisions is that the economy’s underlying momentum was already somewhat less robust than previously thought, even before recent developments pointed to a less rosy outlook.

Last year’s rate hikes, especially December’s, assumed greater economic momentum than was actually the case. Not only that, but whatever momentum the economy had then dissipated more rapidly than expected. That means the Fed needs to both roll back some of last year’s hikes and address the increase in economic uncertainty.

From Switzerland, Federal Reserve Chair Jerome Powell commented on the U.S. economylast Friday. His emphasis on the risks to the outlook reinforced expectations that the Fed would ease at next week’s FOMC meeting.Powell also argued that the outlook for the economy remains favorable because the Fed has shifted the expected path of policy rates downward. An implication of that shift is that the Fed needs to ratify those expectations with lower policy rates or risk an unwanted tightening of financial conditions. Still, he gave an upbeat assessment of the economy, commenting on strong labor markets and taking the positive view on the August employment report. Powell also noted that inflation is heading back to 2%. That fairly positive outlook dashed any hopes that the Fed would cut 50bp at the next meeting.

Federal Reserve economists attempted to quantify the impacts of trade policy uncertaintyon the US and global economies. They estimate that the first and second waves of trade disputes that have hit the economy will slice over 1% off U.S. GDP by 2020. By this argument, trade disputes are not a potential risk for the economy but instead they are already having an impact, further justifying the easing bias taken by Powell & Co.

Upcoming Data

A reasonable amount of data to think about coming this week. JOLTS on Tuesday, PPI on Wednesday, CPI and initial claims on Thursday, and retail sales on Friday. The inflation data is arguably the most important; if the Fed doesn’t fear inflation, then they can hold their dovish bias. The game becomes much more interesting if inflation heads for 2.5% or higher.

Discussion

The Fed is going to cut rates by 25bp at next week’s FOMC meeting and leave the door open for further rate cuts. One could make the argument that the Fed should just get it over with and fix the yield curve with a 50bp cut. I would be inclined to make a 50bp cut to get ahead of any further deterioration in the labor market. The Fed is not so inclined.

The Fed tends to avoid large rate cuts unless either the data is clearly falling off the cliff or credit markets are seizing up. Neither is currently the case. The data flow remains inconsistent with a recession while the corporate bond market is on fireand U.S. equities could soon see record highs. The Fed will find it difficult to cut rates 50bp in such an environment. Instead, the Fed will take a more cautious approach to policy, pushing down rates in quarter point increments.

Also, the Fed will tend to resist large moves because they do not want to be caught wrongfooted by a surprise improvement in the global economy or a thawing of trade tensions. They surely see how the market rallies on positive trade news and will fear that excessively cutting rates now will set the stage for financial instability or economic overheating if trade tensions rapidly dissipate. To be sure though, should a major negative trade or global event like a hard Brexit occur that make the risks all too real, the Fed would respond with a large hike cut.

I think the most likely path forward for policy after next week is another rate cut in October. I don’t think the trade uncertainty will dissipate sufficiently between now and then to alleviate the Fed’s concerns, nor is there likely to be a sudden improvement in the data flow.

What about more than a total of 75bp of easing? Could it be 100bp? Or 125bp? That’s an interesting question. I currently tend toward a fairly bimodal outlook. Either 75bp is enough action to, as the Fed says, “sustain the expansion,” or the economy will slip into recession and the Fed will push short rates back to zero.At this time, I am having trouble seeing much room between those two outcomes. I remain optimistic however that the economy will follow the first path.Again, it is worth repeating that although the yield curve has inverted, the Fed would typically still resist policy easing at this point in the cycle. Indeed, I think the Fed’s early shift has already yielded some positive results. See, for example, homebuilder stocks.

Still, following the logic of the on-again, off-again advice of Williams, with a 50bp cut the Fed would maximize the chance that they sustain the expansion.I think the Fed would be better off getting some momentum behind the economy now rather than waiting until risks to the outlook actually materialize. There are far too many risks to the outlook to expect they all dissipate easily. Policy uncertainty isn’t going away and will likely increase. Market participants should take note of the increasingly erratic behavior of the White House.You know what I am talking about. And it’s not just trade policy that should be of concern; don’t forget regulatory uncertainty and festering sores in the geopolitical arena (North Korea, Iran).

Bottom Line: The Fed will cut rates 25bp next week. I don’t think everyone will be happy about it; anticipate dissents. Still, don’t focus on the dissents. I get the sense that Powell is more interested in getting policy correct than forcing policy into something that achieves consensus but is not correct. I think the Fed should pull the trigger on 50bp; they are most likely going there anyways and should just get it over with. The Fed, however, will have a hard time ignoring a data flow that they see as still generally solid. Really, it is kind of a small miracle that they pivoted toward easier policy at all.