The Federal Reserve set the predicate for a shift in policy to an accommodative stance later this year by revising downward its forecast on inflation and its estimate on the path of rate policy.
In our estimation, monetary policy is too tight, given the deceleration in the domestic economy, low inflation, contraction in global manufacturing in train, and rising policy risks associated with the trade war that looks to spill over into financial markets, given the president’s comments this week on competitive currency depreciations. While there is clearly a split on the Federal Open Market Committee over whether to cut rates once or twice, it is clear that any notion of policy normalization has ended and the central bank is setting up to lower rates this year.
The shift in policy here is one rarely observed outside an exogenous economic shock to the economy. As of today, seven Fed members are forecasting at least one rate cut, while eight are implying two rate cuts necessary to offset the growing downside risks to the economic outlook. The main takeaway from the shift downward in the rate forecast embedded in the dot plot is that the Fed has become dovish and could very well start cutting rates sooner rather than later, depending on the direction of trade policy and the global economic deceleration in train.
Economic risks skew to downside
The domestic economy hit its cyclical peak in the third quarter of 2018, and we believe risks to the economic outlook are skewed to the downside heading into the second half of 2019 and all of 2020. Today’s FOMC meeting reaffirmed our call for a 25-basis-point rate cut at the September and December meetings of the central bank; that aligns with our RSM monetary model, which implies an optimal policy rate of 1.81% at the current time. The downward revision in the 2019 inflation forecast to a range of 1.5% to 1.6% from 1.8% to 1.9% is the most notable change in the summary of economic projections. That, along with the significant changes in the dot plots, implies the Fed is a less confident in its growth and employment forecast than its public rhetoric suggests.
Pending the outcome of the G20 meeting, we acknowledge that the Fed’s July meeting is live and in play. We think the central bank is well-positioned to await the evolution of data over the next few months, which will likely feature an alignment of hard and soft data implying a contraction in the domestic manufacturing sector. That, along with possible escalation of the trade conflict, will provide sufficient impetus for the Fed to add a little cushion to an economy headed back toward or below its 1.8% long-term growth trend. The market responded by pricing in a 100 percent probability of a 25-basis-point rate cut in July, and a 73 percent probability of another 25-basis-point rate cut in September.
Chairman Jay Powell’s press conference got off to a rousing start with Powell pointing out the negative impact of the trade war on global growth and economic slowdown in China. The dovishness implied by the dot plot rate forecast was reinforced by Powell’s assessment on the quality, composition and risks around the growth forecast. The uncertainty tax caused by trade policy is now exerting a drag on growth and business confidence, and the Fed is creating the conditions to support the economy with a lower federal funds rate.
