Based on recent economic data and policy risk around deteriorating global trade conditions, we now expect the Federal Reserve to reduce the policy rate to a range of 1.75 to 2 percent from 2.25 to 2.5 percent by the end of 2019. Our model now implies a target rate of 1.81 percent; we consider each upcoming meeting of the Federal Open Market Committee to be in play for potential rate reductions. In addition, we have reduced our target range on the U.S. 10-year yield to a range of 1.75 to 2 percent, or a midpoint of 1.87 percent. In our estimation, there is a risk of lower, market-derived rates along the yield curve and further inversion of the policy-sensitive 10-year-less-three–month curve.
While we anticipate rate reductions will stoke auto sales, home refinancing and increases in housing purchases, those moves will not be sufficient to offset the drag associated with increased import taxes, the fading of the 2017 tax hike and the likelihood of the $126 billion fiscal cliff that will begin to weigh on overall growth later this year. Thus, there is significant downside risk to our 2019 growth forecast of 1.8 percent.
Our base case is now organized around expectations of 25-basis-point rate cuts in September and December, which would give the central bank time to account for shifts in trade policy and potential rising import taxes imposed by the Trump administration on Mexico, China, Europe, Japan, Australia and India. Thus, should the multi-front trade war widen, we think the Fed would move quickly to provide a cushion for the endogenous policy shock that would follow, and it is probable that the central bank would add an additional 25 basis points of cuts if growth slows, capital expenditures fall flat and the negative impact of the import taxes spill over into broader household spending.
Financial conditions weaken
Financial conditions excluding housing and technology currently sit at three-tenths of one standard deviation above neutral, reflecting the damage done to financial markets over the past six weeks. Any further escalation would likely send financial conditions into negative terrain and at that point they would become a drag on overall economic activity. While financial conditions including housing and technology stand at 1.6 standard deviations above neutral, they are almost certain to decline toward neutral as the technology sector suffers collateral damage from the U.S.-China trade war. As it is, financial conditions including housing and technology have declined 48 basis points since a 2019 high of 2.153 on May 3. Given that the policy-sensitive U.S. 10-year-less-thee-month yield curve has inverted and currently stands at negative 20 basis points, conditions are ripe for tighter lending, falling liquidity and slower growth for the small and medium enterprises that form the backbone of the real economy.
Given that the policy-sensitive U.S. 10-year-less-thee-month yield curve has inverted and currently stands at negative 20 basis points, conditions are ripe for tighter lending, falling liquidity and slower growth for the small and medium enterprises that form the backbone of the real economy.
Mexico is the second-largest U.S. trading partner by share of combined import and exports, trailing only Canada. With a 5-percent import tariff scheduled to be imposed on all imports from Mexico—equivalent to an $18.6 billion dollar tax hike on American consumers and producers—we are certain that declines in business confidence and outlays on productivity-enhancing capital expenditures will rapidly decline, harming overall economic growth. If that happens, it is almost certain that any legislative movement on NAFTA modernization will for all intents and purposes be dead until after the 2020 U.S. presidential election. As it stands, we are now concerned that the administration may choose to pull out of the existing agreement, causing more significant economic dislocation than we have already priced into our forecast.
The idea that fixed business investment would replace U.S. households as the primary driver of growth should be retired. We now anticipate a decline in capital expenditures in the third quarter of 2019 and are quite concerned that it will spill over into much slower hiring in the second half of the year and weaker consumer spending.
Should the Trump administration raise import taxes on all Mexican imports to 25 percent, or the equivalent of a $93 billion tax hike, by October 2019, it is highly likely that the Fed will move in a much more forceful manner to offset the damage imposed by trade policy even though monetary policy is not particularly well-positioned to have much impact.