Joseph A. Abraham, CFA – Senior Vice President, Direct Client Investments
Not only is this the first time that the Fed has cut its benchmark interest rate in a decade, it is also the first time in anyone’s memory that rates have been cut in a reasonably strong economic environment. While the current economic recovery has not been as robust as most pre-2008 economic recoveries, it is reasonably clear that consumer demand, GDP growth, the job creation numbers, and a host of other economic indicators strongly suggest an economy that is not weakening.
So why cut rates now?
The Fed has indicated that the economic headwinds from abroad and the dissonance on trade policy emanating from Washington are of sufficient concern to warrant an “insurance cut”, effectively sending a market a strong signal that the Fed is being vigilant to even the potential of any economic deceleration in the US.
Little noted in the press, but probably high on the Fed’s own radar, is the experience of the European Central Bank (“ECB”) in 2011. In that year, the ECB felt comfortable enough to start raising rates again. It said that it wanted to return to its “day job” of fighting inflation, even though the economic environment was still tenuous, and inflation was nowhere to be found. No other major central bank followed. The fact that Greece was tottering was not of enough concern. The ECB was able to deliver only two 25 bps rate hikes (raising rates from 1% to 1.5%) before it was forced to retreat. The contagion from Greece spread to Portugal, Ireland, Spain and even enmeshed Italy. Reversing the two hikes was insufficient to stem -let alone reverse- the damage. In retrospect, that decision to hike has been recognized as a major policy error. But it exemplifies the difficulty that central bankers face when presented with a myriad of serious, and often conflicting, policy issues.
The US economy was on modestly firmer footing in 2018 when the Fed delivered 4 rate hikes. But when it was determined that those hikes were destabilizing, the Fed put further increases on hold and now is in the process of undoing at least one of them.
Where we, the Fed, and the economy all go from here remains to be seen. Clearly, this novel approach by the Fed is a work still in process, with a wary Fed sailing on uncharted waters.
Brian P. Meaney, CFA – Vice President, Portfolio Manager and Taxable Strategist
The FOMC will announce their rate decision at 2pm today. The consensus opinion is a 25 basis point cut, in line with futures market pricing. After raising the target range to 2.25%-2.50% in December 2018, the Fed became concerned that financial conditions were tightening severely while inflation remained below its 2% target. In recent months, their outlook has become less certain as global growth slowed, particularly in manufacturing, inflation fell and trade tensions resurfaced. The difference in yield between 3 month and 10-year Treasuries inverted, a reliable recession indicator.
While it’s true the US consumer has remained strong, in an interconnected world, the Fed is worried the global slowdown may migrate here. ECB President Mario Draghi stated last week the Eurozone outlook is “getting worse and worse”. Fed officials believe it is better to act now, knowing monetary policy operates on a lag, to support growth. Realized inflation and market-based expectations have fallen this year, giving the Fed room to ease despite historically low unemployment. The idea of “insurance” cuts is not new. The Greenspan Fed cut rate 50 basis points during the Russian debt crisis before resuming its tightening campaign seven months later. The economy continued to grow for a few more years.
25 versus 50
The consensus is 25 basis points, but there is a case for 50 basis points. In a typical rate cutting cycle, the Fed eases by 500 basis points. With half the policy space, the Fed may wish to get the maximum impact for each rate cut. Since the market is priced for 25 basis points, a deeper initial cut could surprise the market and increase inflation expectations. This may have the added benefit of reversing the yield curve inversion. Regardless of 25 or 50 today, the bond market is expecting about 75 basis points of easing this year alone. Chair Powell’s press conference will be an opportunity to present today’s action within the future path of policy.
