Reductions or increases in U.S. Federal Reserve’s policy rate are often like trying to kill a mosquito with an anvil; they may get the job done but the fallout is always widespread and sure to cause a commotion. So it is with today’s rate cut as the Federal Open Market Committee sought to provide a cushion to a rapidly deteriorating global economic environment that will likely spill over into the U.S. economy and muted inflation.
The FOMC followed through on its widely anticipated 25-basis-point cut in the federal funds rate to a range of 2 to 2.25% from 2.25 to 2.5&. In addition, the Fed adjusted the interest rate paid to banks for deposits they hold with the Fed (IOER) and ended its balance sheet reductions, which, on the margin, should improve liquidity conditions in the fixed-income and credit markets. Our base case this year has been that the Fed would reduce the policy rate by 50 basis points with cuts in July and September.
The one-year-old trade war has disrupted and adversely affected the global and domestic manufacturing sectors, and the Fed policy shift is just one aspect of the fallout from that disruption. The Fed is well aware of how variations in automotive and aerospace production tends to cause large movements on a quarter-to-quarter basis in gross domestic product. Consequently, the central bank clearly preferred to buy a bit of insurance against the negative impact of slowing domestic industrial production and the negative externalities linked to what may be a widening trade war with China and a potential tariff war on automobiles with the European Union and the U.K.
Given the risks around Brexit, the U.S.-China trade war and a potential automotive tariff war, the reduction in the federal funds rate now better aligns the U.S. central banks with the broader cycle of rate cuts by global central banks now under way.
In our preview earlier this week, we noted that FOMC Gov. Randal Quarles, Boston Fed President Eric Rosengren or Kansas City President Esther George would likely dissent. Today, we believe that George and Rosengren each took one for the team and expressed their dissent on the rate cut, which is surely one of the more controversial in memory. Two dissents are very rare indeed.
The Fed’s statement was quite similar to its June communique and reads as dovish, thus strongly implying a rate cut at the September, 2019 meeting, which affirms our base case.
Press conference details uncertainty
The post-statement press conference featured a carefully calibrated dance between Chair Jerome Powell and the financial press about the direction of the policy path and the reasons behind the policy shift. Powell several times referred to the uncertainty caused by escalating trade tensions and global trade flows. In our estimation, this was Powell signaling to investors that the balance of risks, in his opinion, are linked to trade policy without explicitly calling out the White House. This complements one of the key aspects of the statement, which reads: “this action supports the Committee’s view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective are the most likely outcomes, but uncertainties about this outlook remain.”