After spending much of the year battling the forces of uncertainty weighing on the economy, the Fed declared victory today. Absent a fresh deterioration in the economic outlook, Fed Chair Jerome Powell and his colleagues believe they are done cutting rates with this month’s policy move. Expect an extended policy pause; the Fed is neither interested in easing policy further given their outlook nor in soon raising rates back up given continued below-target inflation.

Going into the meeting, I thought the Fed would set more conditionalityaround the next policy move. The Fed did not disappoint. The statement set the tone with the Fed dropping the phrase “will act as appropriate to sustain the expansion.” That phrase had become the coded message signaling that future rate cuts were more likely than not. Its removal alone was a clear shift in messaging that another rate cut was not currently under consideration.

In the post-meeting press conference, Powell removed any doubt that the Fed saw this cut as the end of their mid-cycle adjustment, stating “We see the current stance of policy as likely to remain appropriate as long as incoming information about the economy remains broadly consistent with our outlook.”

This is a fairly straightforward message establishing conditionality around any further rate cuts. A status quo economic outlook, which was sufficient to justify this rate cut, would not be sufficient to justify another. Powell wanted to make a clear signal about the kind of data that would force the Fed into another cut. That data would have to be sufficient to materially negatively impact the Fed’s economic outlook. To make a complex analysis concise, another rate cut requires a constellation of data indicating substantial, sustained upward pressure on unemployment.

The Fed isn’t seeing such data as likely, and hence don’t expect to cut again. Still, this isn’t as hawkish as it might seem. Although the Fed doesn’t intend to cut rates further, they also don’t expect to raise rates in the foreseeable future. It will take more than just an easing of the risks to the outlook for the Fed to reverse this series of cuts. According to Powell, the Fed won’t hike rates until they see a persistent and significant upward inflation move. That also isn’t in their outlook.

Policy is appropriate with neither easing nor tighter policy needed given the current outlook. That’s the recipe for an extended pause.

Of course, this forecast, like all the Fed’s forecasts, for rates is data dependent. Powell did not take the possibility of a rate cut off the table entirely. But it is easy to tell a story where the data takes a cut off the table for him. For instance, mixed regional purchasing manager indexes suggest that the manufacturing cycle may be bottoming out; if so we could soon see better news from the nation’s factories fairly soon. If that happens while the jobs market stays solid (as expected to be the case in the upcoming employment report for October, after accounting for any temporary strike-induced weakness), the Fed will see no reason to cut further.

Bottom Line: All else equal, as long as the data remains consistent with growth around 2%, the Fed isn’t cutting rates. And as long as the data remains consistent with inflation at (and certainty below) 2%, the Fed isn’t inclined to hike rates either. Such a “policy pause” forecast feels like a good baseline going into the end of the year. After a fairly hectic year, Powell and his colleagues are moving off to the sidelines.

The Federal Reserve will lower interest rates Wednesday for the third time since July, erring on the side of caution in an effort to spur economic activity and offset risks to the outlook. Still, the data doesn’t justify an endless series of rate cuts, and the Fed will need to start signaling more explicitly to the financial markets what economic conditions will bring what the central bank calls a “mid-cycle correction” to monetary policy to an end.

Continued at Bloomberg Opinion….

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.

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….

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….

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.

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.