Market participants will know soon enough whether the US Federal Reserve has led them into another “dove trap” and will need to reel in expectations for interest-rate cuts. The next 48 hours will be critical in markets, with Fed Chairman Jerome Powell appearing twice before Congress for his semi-annual testimony and the release of the minutes from the central bank’s last monetary policy meeting three weeks ago.
Although it’s no secret that Fed policy has turned dovish this year, it became even more so with comments by Powell in early June where he signalled an openness to rate cuts stemming from growing global trade tensions. The Fed then formally abandoned its “patient” policy guidance in favour of an intention to act as necessary to “sustain” the expansion, and the Federal Open Market Committee revised its interest rate forecasts lower three weeks ago. Almost half the members of the FOMC anticipated that the Fed would cut rates this year.
In the context of softer economic data and growing global risks, this dovish shift left little doubt that the Fed intended its next move to be a rate cut. In fact, it sounded as if they were almost pre-committing to a reduction at their next monetary policy meeting at the end of this month. The Fed must have known this is how market participants would interpret their rhetoric. Indeed, Powell’s early June comments in Chicago were at a conference populated by many of the most notable Fed watchers. The audience was exactly the group primed to read a
message into his remarks.
Wall Street bought into the Fed rate cut story, with yields on US Treasuries tumbling to their lowest since 2017, stocks posting one of their best months in June in years and the dollar weakening. There was even chatter of a 50 basis-point cut this month, followed by a 25 basis- point reduction by the end of the year. But comments by Federal Reserve Bank of St. Louis President James Bullard, the lone dissenter in favour of a rate cut at last meeting, indicate that even he thinks a 50 basis-point reduction is too much.
It seems unlikely that the Fed would achieve consensus on anything more than a 25 basis-point rate cut later this month. Powell used the analogy of “an ounce of protection is worth a pound of cure” to describe possible policy changes. This also suggests the Fed is thinking in terms of an “insurance cut” that keeps the economy on track for a soft landing.
Assuming that the more hawkish members of the FOMC are willing to acquiesce to an insurance cut, they will demand data showing a sharp slowdown in the economy to justify further rate reductions. The US economy, though, is not yet experiencing the type of broad-based and sharp deceleration in activity sufficient to justify a series of rate cuts at this time. Indeed, there’s a strong argument that the data doesn’t justify the need for a rate cut.
Although the labour market has cooled, it remains hot enough to generate a monthly average of 171,000 jobs over the past three months. The Institute of Supply Management’s indicators for both manufacturing and services remain in expansion territory, core capital goods orders are moving sideways but not collapsing, and consumer spending was bouncing back in the second quarter. The argument for a rate cut hinges on slow inflation and the balance of risks to the outlook.
It’s more of an insurance cut to compensate for the likely unnecessary December rate hike, not a reaction to a substantial risk of imminent recession.
This means the Fed intends to move preemptively in the face of downside risks so that they don’t need to follow with a series of rate cuts. Getting this message across may be challenging considering that we are more familiar with preemptive rate hikes to quell inflation while rate cuts often come too late.
Watch out for the possibility that Powell shifts the tone of his messaging this week by emphasising the underlying strength of the economy and that any policy adjustments at this point would be modest shifts to reinforce the expansion. This would be a clear indication that the markets pulled away from the Fed. And if that’s the case, July markets may look more like May, when the S&P 500 Index tumbled 6.58 percent after the Fed shocked investors by downplaying tepid inflation, instead of June, when the S&P 500 rebounded 6.89 percent.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy’s Fed Watch.