Walking a tightrope on interest rates
Fed walking a fine line as economy grows more vulnerable
Federal Reserve could make first cut in a decade despite a healthy economy
The Federal Reserve will be walking a tightrope this week, analysts say, as it likely signals the possibility of its first interest rate cut in a decade despite a generally healthy economy.
Central bank policymakers want to set the stage for a potential late July rate decrease without suggesting the move is a foregone conclusion, without raising concerns that the economy already is weakening and without creating the impression that Fed officials are simply placating a volatile stock market, economists say.
“They’re definitely trying to thread the needle,” says Jonathan Millar, deputy chief U.S. economist at Barclays Capital. After a two-day meeting that concludes Wednesday, the Fed is scheduled to release a statement and Fed Chairman Jerome Powell will hold a news conference.
Trade fight ramps up
Driving the Fed’s nuanced mission is President Trump’s trade war with China, which could intensify within weeks if the president and Chinese President Xi Jinping don’t reach some type of détente at the G-20 meetings in Japan this month.
The U.S. already has slapped tariffs on $250 billion in Chinese imports, and China has retaliated with tit-for-tat duties on U.S. shipments. The bigger concern is Trump’s plan to tax the remaining $300 billion in Chinese products, including popular consumer items such as toys, clothing and electronics.
Even that move likely would reduce U.S. economic growth next year by a still-manageable three-tenths of a percentage point, Oxford Economics says, as consumers pull back spending and manufacturers face higher costs for parts. But the ripple effects on consumer and business confidence and spending, and stocks, would be far more damaging and could well tip the economy into recession, says Mark Zandi, chief economist of Moody’s Analytics.
Economy is still solid
That’s where the Fed comes in. The economy is in decent shape. The strong May retail sales growth that the Commerce Department reported last week will likely translate into robust consumer spending and better-than-expected economic growth of about 2% in the current quarter. That follows healthy growth of about 3% both last year and in the first quarter.
the economy is expected to slow in the second half of the year as the effects of federal tax cuts and spending increases fade. Business confidence and investment have flagged recently. Average monthly job growth has fallen from 223,000 in 2018 to 164,000 so far this year, though the latter is still more than double what’s needed to keep pushing down unemployment. And global growth has softened.
In other words, the economy is vulnerable. And if Trump and Xi don’t reach a deal that at least staves off tariffs on the remaining $300 billion in Chinese imports, the 10-year-old economic expansion could come to a halt.
‘Insurance’ rate cut?
Normally, the Fed cuts rates when the economy wobbles noticeably or already has entered recession. This time, however, the Fed is likely to tee up the possibility of an “insurance cut” to rates that snuffs out the seeds of a recession, depending on the outcome of the TrumpXi talks, economists say.
“They just would want to avoid the possibility that a recession dynamic is going to take place,” Millar says.
The Fed made such preemptive rate cuts despite a solid economy in 1995 and 1998 amid lower corporate profit forecasts and the Russian financial crisis, respectively.
The moves helped extend the 1990s economic expansion, Millar says.
A big reason the Fed might take a similar step this summer is that its benchmark interest rate still is historically low at a range of 2.25% to 2.5% despite nine rate increases since late 2015. That, Millar says, gives Fed officials little room to cut rates in a downturn and an incentive to do everything they can to avoid one.
“It might be too late to respond once the data confirm a significant softening,” Millar says.
Meanwhile, he says, the Fed’s preferred measure of inflation is still well below its 2% target, presenting little risk of a spike in consumer prices if rates are reduced.
Fed: From patient to flexible?
Morgan Stanley says the Fed is likely to open the door to a July rate cut this week by removing from its post-meeting statement a promise to be “patient” as it waits to see where the economy is headed.
Instead, it could say that if a “downside risk” to its outlook emerges, it will “act as appropriate to sustain the expansion,” the research firm says.
This month, Fed chief Powell, referring to the widening trade war, used similar language in a speech, stanching a stock sell-off and propelling markets higher.
Fed fund futures markets now expect at least two quarter-point rate cuts this year and two more by the end of 2020. Barclays is forecasting an unusual halfpoint cut in July.
That means if the Fed doesn’t at least signal the possibility of lower rates, “it wouldn’t be surprising” for stocks to fall sharply, says Ryan Detrick, senior market strategist for LPL Financial.
Are markets too primed for cut?
At the same time, Fed policymakers don’t want to convey that they’re prepared to trim rates simply to prop up stocks.
“If investors think (the Fed) is always going to step in, they could take excessive risk,” Millar says.
Mark Haefele, global chief investment officer for UBS Wealth Management, says the market is overstating the potential for rate cuts, noting Powell “didn’t promise” one. And the market’s expectation for four cuts by the end of next year “would only be justified by a recession, which we see as unlikely,” he wrote in a note to clients.
Another challenge Powell faces is paving the way for a possible rate decrease next month without conveying that the move is a fait accompli, says economist Michael Feroli of JPMorgan Chase.
“This will be a difficult balancing act,” Feroli says.
That’s why Paul Ashworth of Capital Economics thinks the Fed will surprise investors and take a more cautious approach, leaving out of its statement any assertion that it’s ready to support the expansion.
“I just don’t think there’s any evidence that there is a need for a preemptive panic rate cut,” Ashworth says.
Economists do agree on one thing: Fed policymakers are unlikely to forecast any rate cuts in their official projections.
But their median estimate of no rate hikes this year and one in 2020 likely will be revised to no hikes through next year, Morgan Stanley says.