As expected, the Federal Open Market Committee (FOMC) this week held steady on both the fed funds rate (2.25%–2.50%) and the interest on excess reserves (IOER, 2.35%). But, more importantly, the FOMC statement emphasized higher economic uncertainty, and FOMC officials weighed rate cuts in response to this more uncertain economic outlook. Indeed, roughly half of the FOMC officials are now forecasting 50 basis points of rate cuts will be appropriate before year-end 2019, while many of those who are not currently forecasting a cut, according to Fed Chairman Jerome Powell, “agree that the case for additional accommodation has strengthened since the May meeting.”
The Fed’s policy outlook now appears largely in line with PIMCO’s expectations that the policy outlook is binary: If U.S.–China trade tensions aren’t at least deescalated around the G-20 meeting or if other downside risks to the U.S. economy materialize, we see the potential for a 50 basis point policy rate cut as early as the July 31 FOMC meeting.
Conversely, if trade tensions improve and economic data is stable, we expect the Fed will try to delay taking any action.
Uncertainty underpins dovish tone
The tone of the FOMC statement and press conference was a notable shift from the May meeting, where Chairman Powell declined to discuss the economic conditions that would warrant rate cuts, and instead emphasized the still solid economic outlook and pointed to various transitory factors that have recently negatively affected core PCE inflation (personal consumption expenditures – the Fed’s preferred inflation measure).
To be sure, much has changed since that meeting, greatly increasing the uncertainty around the economic outlook. The Trump administration’s threatened tariffs on Mexican imports, though they were not implemented (at least not yet), along with escalation of tensions with China, have driven tremendous uncertainty in the U.S. economic outlook.
While our baseline outlook remains that the U.S. will avoid a recession at least over the next year or so, the renewed prospect for more economically disruptive trade and foreign policies, occurring while U.S. growth is already decelerating, greatly increases the risk of a more notable fall in economic growth or even an outright recession, in our view.
In the face of these downside risks, we are not surprised that the Fed is discussing cuts. Although the central bank has some room to ease monetary policy in the event of a more pronounced downturn, the zero or “effective” lower bound (ELB) is still an important constraint. Our view – which we believe a number of Fed policymakers share and which Chair Powell mentioned during today’s press conference – is that this ELB constraint argues for a “stronger sooner” easing response when faced with greater downside risks to the outlook, even if a recession isn’t expected. If this more forceful approach ultimately reduces the chances of returning to the ELB, it appears to be the more prudent risk management strategy. This also supports the idea that the Fed will be pre-emptive – policymakers likely won’t wait until they see a meaningful slowdown in the economic data (which has a one- to two-month lag) to act.
If the Fed doesn’t cut
Financial conditions are back near year-to-date lows (though still meaningfully tighter versus 2018) on the back of markets already pricing in Fed rate cuts. Should the Fed fail to deliver on market expectations for cuts, we expect financial conditions to tighten materially.
On the other hand, if trade tensions improve and U.S. economic data are stable, we expect the Fed to try to delay taking any action, while carefully navigating the impact on financial conditions given market expectations following the June 18–19 FOMC meeting. That said, after the significant dovish changes at the June meeting, the Fed has limited additional tools to communicate dovishness without actually cutting going forward.
© PIMCO
© PIMCO
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