Second Slice: Fed Cuts Rates Again, But Next Move Uncertain Amid Divided FOMC

 | Sep 19, 2019 03:27AM ET

(Wednesday Post-Fed) The Fed’s not in the business of delivering surprises. That’s why today’s 25-basis point rate cut—the second in less than two months after 10 years without one—probably came as most investors expected.

The benchmark fed funds rate is now in the 1.75% to 2% range, back to where it was roughly a year ago, as the Fed pedals furiously to keep the long U.S. expansion going even as economies in Europe and Asia seem to be slipping into slow motion.

The real question is what comes next, and that’s why people are taking a close look at the Fed’s latest statement and “dot plot ” to get a sense of whether this is the last cut of the year or if there’s a chance of another. It may be an actual surprise to hear that the Fed itself doesn’t agree on this. With that in mind, it looks like rate policy will remain a “meeting by meeting” decision based on data and the risk picture, Fed Chairman Jerome Powell said in his press conference.

“We’re not on a pre-set course,” said Powell, admitting that this is a “challenging” time.

Lack of a definitive promise for more rate cuts appears to have put stocks under pressure late in today’s session. The dot plot shows five members thinking the Federal Open Market Committee (FOMC) should have held its previous range of 2% to 2.25%, five approve of the 25 basis point cut but want to keep rates there through the rest of the year, and seven favor at least one more cut this year, CNBC noted.

There’s really no easy landing spot, and it’s more difficult because there’s also a bit of a conundrum in the U.S. economy now. “Household spending has been rising at a strong pace,” the Fed said in its statement today, but “business fixed investment and exports have weakened.”

This could be a way of alluding to the trade situation, where tariffs are apparently starting to have an impact on company investment due to uncertainty about how they’ll ultimately play out. Consumers have been keeping things going at home, as the Fed noted by putting stronger language around the spending dynamic this time around, but some analysts believe it’s unclear if this can last beyond the holidays if there’s no definitive outcome on trade.

Powell Notes Weakness Abroad

In his remarks after the decision, Fed Chairman Jerome Powell noted “weakness abroad,” low U.S. inflation, and U.S. business uncertainty in the light of the trade situation. The Fed, he said, has dialed down its ideas of where “appropriate” rate policy should be, and has adjusted to take this into account.

Get The News You Want
Read market moving news with a personalized feed of stocks you care about.
Get The App

“Global growth has weakened…and political risks like Brexit remain unresolved,” Powell said at his press conference. “Uncertainty about trade policy has discouraged (companies) from investing in their businesses.”

Powell said the FOMC still expects U.S. gross domestic product (GDP) growth to remain “moderate” at near 2% this year and next, and unemployment to stay below 4%. However, he noted that inflation expectations remain at the low end and inflation hasn’t reached the Fed’s 2% goal. He expects the 2% goal to be reached, but in the meantime, “continued below-target inflation could lead to an unwelcome slide in expectations.”

Deflation can be a self-reinforcing psychology, encouraging people to wait before making purchases on hopes prices will fall. That’s the kind of deflationary spiral the Fed hopes to avoid.

Powell says the labor market remains strong, with wages rising “particularly for lower wage jobs,” which is allowing more people to participate in the job market.

However, “Global growth continues to weaken,” even since the Fed’s last meeting, a risk that the Fed sees as more heightened now, Powell said.

Growing Dissent on FOMC Could Make Next Meetings Tougher

It’s also interesting to see a growing dichotomy among Fed voters, with three of them dissenting this time around. One wanted a 50-basis point cut, while two wanted no cut at all. Dissenters included some of the usual hawks and doves.

This is the second time in a row we’ve seen people dissenting, which makes it seem like it could be tougher for the Federal Open Market Committee (FOMC) to reach consensus the next few meetings. What didn’t change from the last statement back in July is the Fed saying it will continue monitoring the economy, a possible sign that FOMC members could simply decide to watch the economic data roll in before deciding on next steps. Last time out, the Fed didn’t satisfy doves who wanted it to announce it’s on a steady rate-cut course, and it seems unlikely that will happen anytime soon.

Another question is where a so-called “neutral” fed funds rate might be. Earlier this year, some analysts and economists thought it was somewhere around 3%. Now, the Fed has taken rates back below 2% and there’s still widespread belief, judging from the futures market, anyway, that it could move rates even lower. Does that mean a neutral interest rate is also edging down, or is the fed funds rate downshifting out of neutral and into low gear?

A “neutral” rate, by the way, is one that’s supposed to neither encourage nor discourage borrowing. The European Central Bank is already offering a rate way below neutral levels, and well below zero. The benchmark U.S. rate remains well above that, but we’ve heard more chatter recently about possible negative rates here lately, with even former Fed Chair Alan Greenspan weighing in on the topic.

Another question mark going into this afternoon’s press conference was the Fed’s future plans for its balance sheet (see more below). Recall that the central bank recently wrapped up a balance sheet reduction program, and already there have been calls for a fresh round of expansion. “It’s certainly possible we’ll have to resume organic growth of the balance sheet earlier than we had thought,” Powell said, noting this is going to be a discussion topic for the Fed.

Laying Out Arguments For and Against

In normal times, it might be unlikely to see rates go down at a time like this. The economy grew nearly 3% last year and is running at around a 2% clip now. That’s not outstanding, but it’s not anything that would necessarily get people worrying about recession, either. Inflation, too, sent some signals last week, with both core producer and core consumer prices rising more than many analysts had expected. Inflation can be a sign of economic strength.

Meanwhile, unemployment remains at 50-year lows. Generally, low unemployment and a growing economy tend to argue against easing borrowing costs, out of fears that the economy could get “too hot,” sparking inflation.

Another argument you could make against rate cuts now is that they’re already ultra-low. With the fed funds rate at just under 2.25% going into the meeting, the Fed doesn’t have a lot of traction to make more cuts if the economy really runs into trouble. There may be some members of the FOMC who’d like to keep the powder dry, so to speak, so they have ammunition to stimulate growth if times get tough.

Historically, the fed funds rate has been around 5%, so it’s about half its normal level. A 5% rate means the Fed could cut a bunch of times if recession hits. A 2% rate means you’re back to zero again pretty quickly. The Fed only has so many bites at the apple before it has to consider more dramatic and less tried and true stimulus tools like quantitative easing or even negative rates.

The factors that had been pointing in the direction of a rate cut included the trade war between the U.S. and China and continued negative rates and poor economic performance overseas. Though the benchmark German bund yield is up a bit from recent lows, it remains way under water. Chinese economic growth continues to sputter, and Argentina is also in tough shape. The Fed might not want U.S. rates to be so far out of line with rates around the world, and the spread between the U.S. 10-year yield and the German 10-year yield is at long-term highs.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/dxy-fed-9-18-19.jpg 800w" media="(min-width: 36em)" sizes="(min-width: 36em) 33.3vw, 100vw" />