The decision to cut rates in July appears a tough call for the Fed. It appears grounded in future downside risks more than the present data, and two policy markers clearly dissented from the decision. Here’s what we learned from the minutes.
Things Are Currently Pretty Good
The Fed is worried mostly about the future, not the present. They see job growth and robust consumer spending. Business investment and manufacturing is indeed soft today. Yet, it’s rare to have everything moving in the right direction at once. Inflation is a little muted and the Fed would like it higher. If there is one thing the Fed is worried about today, it’s manufacturing, beyond that though, things are pretty rosy. In fact, this is the key reason two policy-makers dissented from the July cut. That level of dissent is unusual for the Fed. The dissenters see no major problems in the current data with unemployment around decade lows and markets close to all-time highs. It’s hard to argue with that. The need for a cut is more based on future trends and global issues than the current state of the U.S. economy.
Clouds On The Horizon
Nonetheless, as ever, a broad set of concerns are being closely monitored by the Fed. These include the risks of a no-deal Brexit, U.S.-China trade tensions, an inverted yield curve, weak energy prices and various problems in the agricultural sector. Also, we should note, that unemployment though in a good place, is technically moving in the wrong direction since the current rate of 3.7% is above the recent low of 3.6% but this could prove to be statistical noise. There was some discussion of upside risks too, for example resolution of trade tensions, were that to occur, could provide a real boost to markets on the Fed’s view.
Basically, three key factors worry the Fed today. First off, things do appear to be getting worse for business investment and the manufacturing sector. If that trend continues it could become a real problem for the U.S. economy. Second, things are worsening in many regions of the world beyond the U.S. and with interest rates so low in most countries, the immediate policy solution of rate cuts is less obvious and riskier than normal. Finally, inflation is a key target for the Fed and has historically trended below target. The Fed would like to get inflation closer to the 2% target rate. These are the main factors that drove the rate cut.
Based on the notes, the Fed’s next steps are unclear. There is relatively high level of dissent even for the cut that already occurred, and perhaps further cuts would bring more dissent unless the immediate data supported it. The July cut seems more an insurance cut than a fundamental change of direction for the Fed. Plus it’s unlikely post-meeting data, which has been relatively positive so far, has swayed the two dissenters from the July meeting.
At the same time, the financial markets are expecting further cuts in 2019, perhaps as many as three more in 2019 based on futures data. Interest rate futures view a September cut as virtually certain at this point, yet it isn’t clear that the Fed is there yet. That’s a problem that the Fed with its emphasis on predictability needs to manage. Either the markets are seeing a host of weak economic data coming in before September’s meeting. Or the Fed’s current view wins out and the downside risks, though possible especially in manufacturing, do not materialize. In this case the markets may be disappointed that further cuts don’t arrive. Either way the equity markets may be set up for disappointment, either from bad economic news or the Fed’s refusal to embark on a host of further cuts in 2019.