The Fed turned more dovish than I anticipated, basically announcing a July rate cut as clearly as they could without taking out an ad in the Wall Street Journal.
The story begins with the Fed’s statement. The Fed dropped its “patient” stance in favor of a pledge to “act as appropriate.” Given the increased “uncertainties” to the outlook and the “muted inflation pressures” the only logical direction for policy is to cut rates. This shouldn’t be a surprise – the proximity to the lower bound coupled with low inflation was always going to lead the Fed to err on the side of a rate cut. It just took them some time to find their way there.
But the story was just beginning. The dot plot was far more dovish than I anticipated. I expected one policy maker anticipating lower rates, thinking of St. Louis Federal Reserve President James Bullard (who dissented). Instead, there were eight participants expecting lower rates, seven of them 50 basis points. While not enough to change the median of the forecasts, it clearly indicated the leaning of the participants.
The forecasts were dovish as well. The inflation forecast, the longer-run unemployment rate, and the longer run interest rate were all marked down. The reduction of the longer run interest rate from a median forecast of 2.8% to 2.5% was particularly relevant. That tells me that the shift in the outlook is more about a fundamental reassessment of the level of financial accommodation in the economy than a reaction to just the trade disputes. The Fed is acknowledging that policy has been less accommodative than they believed. The persistence of low inflation likely helped them reached that conclusion.
Federal Reserve Chair Powell did nothing to push back on a dovish interpretation of this meeting. Notably, he downplayed any divisions that might be implied be the dot plot, saying that even those who held rate forecast steady were leaning toward additional accommodation. He expressed greater concern about inflation and did not try to emphasize low inflation as transitory. He didn’t appear fazed about the prospect of a 50bp cut. He acknowledged research supporting more aggressive policy moves when near the zero bound. He talked about the importance of sustaining low unemployment. It all points to an imminent rate cut.
Equity and bond markets rallied as might be expected. Interest rates dropped more sharply at the short end of the yield curve; the 10s2s spread steepened as I would anticipate to happen if the Fed enters an easing cycle. Market participants have priced in a 100% change of a rate hike in July. The 2 year treasury yield is also begging the Fed to cut rates.
Yes, there is some commentary that this July cut is conditional on trade talks or data. I don’t think so; it would take some spectacular data to call the July cut into question. Powell and his colleagues knew exactly how the market would react to this meeting and did nothing to push back against that reaction. It would be exceedingly difficult to pull back on a rate cut now.
Nor is there any reason to. Yes, financial stability concerns linger in the background. I think though the Fed will weigh more heavily meeting its employment and inflation mandates. The persistently low inflation leaves them room to ease and protect against downside risks to employment. It important to lean against those risks given the proximity to the zero lower bound. It is also important to lean against those risks because you don’t want to go into a recession with low inflation.
Bottom Line: The Fed greenlit a July rate cut. The dots suggest more will follow, with a minimum of 50bp on the way. While I think July is pretty much locked in, future cuts are of course data dependent.