The Fed Keeps The Market Hoping For a Rate Cut That Might Not Arrive Soon

The Federal Reserve recent monetary policy meeting ended, as expected, with no rate cuts, but it moved a bit towards considering lowering rates. Despite the dovish rhetoric from Chair Jerome Powell, the Fed’s signal to lower rates in the dot plot, the market is still too optimistic about the Fed moving on cutting rates as early as next month. This overoptimistic view might mean market disappointment in the upcoming July meeting.

Source: FOMC

The Fed made some changes to the statement, economic outlook, and dot plot (see charts below) that could suggest a rate cut is possible this year. Also, some analysts think the Fed is likely to “surprise” with a rate cut in July in an attempt to revise expectations. Despite these changes and projections, I think it’s less likely that the Fed will move in July.

Moreover, in September, it might move only if more incoming economic data were to show signs of weakness. And Powell pointed out that he and the committee would like to see a change in trend and not just a single data point to assess the direction of the U.S. economy:

“Consumer spending is solid supported by, you know, healthy job market, high levels of employment, wages going up. We do see those, some areas that we are looking at such as I mentioned business fixed income. So, also the prolonged shortfall and inflation and perhaps job growth, we don’t like to look at one job report, we like to average over three or six months, but still that bears watching.”     

The concerns of global economic growth, trade war rhetoric, and some weakness in economic data have made the Fed leaning towards lowering rates even this year (7 members (out of 17) thought of cutting rates twice this year, but only one (Bullard) thought of cutting rates today).

However, why would the Fed want to cut rates as early as July? It will only receive one more data-point on both retail sales, inflation, and jobs – even if these reports come a bit soft, would that be enough evidence of a change in trend? The Fed might consider lowering rates soon to buy “recession insurance”, however that could also be done in September – a couple of months won’t make much of a difference for this reasoning. Also, surprising the markets by cutting rates when no one expects, requires the market to think it is unlikely the Fed will cut rates, however, both equities and bonds are pricing in at least two rate cuts. This state, where the market is already pricing at least two cuts, makes it harder for the Fed to surprise unless it goes out of its way to surprise and cuts by 50bp in July for example.  

However, there is one possible divergence between the bonds and equities markets: Bonds markets have revised down the odds of a July rate cut from 86% (June 17) to 40% (June 20). While equities have continued to rally as if the Fed is aiming to cut rates next month. This divergence could reach a turning point in the July meeting or even sooner if the next jobs and retail sales reports show strength.

In the end, I think the Fed is not sure if it should cut rates this year and when. In the meantime, it will likely take its time before delivering this stimulus by watching how the economic data — from the U.S. and other countries — and the trade war are unfolding.     

Dot plots for March and June meetings

Source: FOMC

Fed’s economic outlook for September 2018- June 2019

Source: FOMC