Will the Fed cut rates further, or pause at the next meeting?:
Long Run Forecast Vs. Short Run Reality, by Tim Duy: Recent Fedspeak has, in my opinion, been very clear – current policy is balanced and the bar for another rate cut in December is set high. Only evidence that growth will be substantially below already low expectations would prompt a rate cut. The minutes of the last meeting, however, present a puzzle. There was apparently lengthy discussion of downside risks, yet the final decision was supposedly a “close call.” And despite these numerous downside risks, and a positive trajectory for inflation, the statement defined policy as roughly neutral. The mix of signals leaves perfectly reasonable people with completely opposing opinions about the Fed’s intentions for future policy. One can read the minutes and find reason for pause, but also find a risk management motivation for another cut.
How can we resolve recent Fedspeak, the minutes, and the growth forecasts? Thinking on that question occupied a good part of the long holiday weekend. It appears that the Fed is preparing market participants for a pause in rate cuts before the economy has bottomed out. They would like December to be an opportunity for a pause. But assuming the continuing instability in financial markets, I suspect they will not be willing to risk a pause just yet.
One purpose of increasing transparency via the enhanced forecasts is to minimize the fluctuations of policy. I doubt anyone believes that wide swings in policy – such as the drop to 1% and the subsequent rise to 5.25% - are conducive to economic stability in the long-run. The long run forecast, both for growth and inflation, are intended to create a policy anchor from which the Fed can tie the economy with a short tether.
The Fed’s long term forecast suggests they see the economy’s potential growth rate near 2.5%. This reflects a combination of slower productivity and labor force growth. The inflation forecasts reveal an inflation target of 1.6% to 1.9%, with a midpoint of 1.75%. Combined, this suggests a range of the neutral fund funds rate at roughly 4.0% to 4.5%, with the current rate at the top end of this range. Hence, given this estimate of neutral, the Fed can reasonably conclude that current policy will “promote moderate growth over time” and that the risks to growth and inflation are equally balanced.
You might argue that given we are at that high end of the range, policy remains a tad bit tight relative to neutral. True enough, although the Fed might have cause to expect that ongoing high headline inflation deserves extra attention. From the minutes:
Participants were concerned that if headline inflation remained above core measures for a sustained period, then longer-term inflation expectations could move higher, a development that could lead to greater inflation pressures over the longer term and be costly to reverse.
Still, 25bp is not worth quibbling over – the point is that we are in the Fed’s estimated neutral range, the range of policy intended to hit the Fed’s long term goals. This, of course, has been the point of recent Fedspeak – their forecast implies a “rough patch” in the short run, but they are looking to the other side of that patch. They want us to look to the other side as well.
The Fed wants market participants to look to the other side because they do not want policy to stray too far from their neutral range. They do not want current policy to breed conditions that foster future instability, such as, for example, an extended period of ultra low interest rates that supports an asset price bubble. In order to keep current policy tethered to the long run anchor, the Fed needs to shift policy before the need is obviously evident. Which means doing something that might be surprising to market participants, such as pausing when inflation trends may still be on the uptrend (sound familiar?). Or, what is likely most challenging, pausing in an easing cycle when the economy remains weak.
Of course, it is the latter situation that the Fed is facing. Policymakers intend to pause at a time that may be somewhat “uncomfortable,” when it is not clear the economy has reverted to its upward trend. Convincing market participants, however, that they are not going to cut rates until the skies are blue again is a challenge for a number of reasons:
1. The previous easing cycle was deep and prolonged, setting expectations for how an asset bubble burst should be managed.
2. The Fed came out of the gate with a 50bp cut in a high growth quarter, suggesting a willingness to cut deep.
3. The Fed consistently downplayed the risks of the housing bubble to the general economy, and now has some credibility issues when it comes to judging the extent of the downside risks.
Consequently, policymakers feel inclined to keep up the tough talk, reminding investors not to lose sight of the long term forecast. This creates the stage so that when the financial and economic conditions become conducive for a policy shift, expectations will swing in that direction.
There is, of course, some credibility risk for the Fed in repeatedly stating their benign forecast if they keep cutting rates. That is the current situation, as it appears that conditions are not conducive for a pause in December. That is what markets participants are saying by betting on continued rate cuts, effectively ignoring the steady stream of hawkish Fedspeak.
To be sure, the Fed could simply ignore market participants and surprise with a pause, but if financial markets keep deteriorating over the next two weeks, I don’t think they will risk a surprise. From the minutes:
Participants generally viewed financial markets as still fragile and were concerned that an adverse shock—such as a sharp deterioration in credit quality or disclosure of unusually large and unanticipated losses—could further dent investor confidence and significantly increase the downside risks to the economy.
While the Fed would never say they were driven by market expectations, they also know that failing to meet the expectation of a rate cut is the same thing as an “adverse shock.” There is a time and a place for a credibility building negative shock, but I doubt the Fed believes that that time is now. That is the risk management side of policy.
But that time will come – the Fed will continue to remind us of the long term forecast to keep us ready for that time. I believe the Fed intends to avoid a repeat of their response to tech bubble collapse, which means we are not on a runaway rate cut train. But the train is not ready to stop just yet.
Bottom Line: The conflict between the long term outlook and the short term risks leaves this once again a close call. Although the Fed would be happy to pause, recent deterioration in financials markets, including a flight to quality that threatens to push the 10 year rate below 4%, will make it difficult for the Fed to follow through on their hawkish rhetoric. But there is a point to the rhetoric – to keep us focused on the future, which the Fed can affect, not the present, which is already written in stone. The Fed will leap at the first opportunity to pause. For December to be that opportunity, markets need to stabilize and data need to conform to the Fed forecast.