Markets should not be confused by the FOMC
Communication that followed yesterday's decision by the FOMC to
cut interest rates, announced via a statement that seemed to hint
that future cuts were possible but not highly likely and followed
by the Chairman's press conference, seemed to catch markets
off-guard and uncertain about the most likely course of Fed
interest-rate policy over the next several FOMC meeting cycles. We
can explain the source of the confusion and contrast market
gyrations hinting at confusion with our view that was entirely
consistent with yesterday's developments at the FOMC. We continue
to anticipate that the most likely outcome is for no further cut in
interest rates this year and that a reversal of yesterday's rate
cut is likely in the future, most probably in 2020, barring a
significant downside surprise.
Wednesday at the FOMC
First, the FOMC announced via statement a quarter-point cut in the funds-rate target to a range of 2% to 2¼%. We had expected the cut, but market pricing suggested some investors anticipated a larger 50 basis-point cut. Second, the wording of the statement reflected mostly solid incoming economic data alongside some concern about a global slowdown and muted inflation. Third, the phrasing of the policy section was altered, seemingly to tone down expectations for further rate cuts. Specifically, the phrase "closely monitor" in terms of risks and uncertainties was replaced with "continue to monitor," a more benign wording that suggests a lower level of concern.
Over the course of the afternoon, markets gyrated, apparently reflecting confusion about the outlook for Fed policy. At one point during the afternoon, the S&P 500 was down approximately 2% from its previous close, then rallied (unevenly) to finish down 1.1% at 2,980. The 10-year Treasury yield ended down 4 basis points at 2.02% after fluctuating sharply. This morning it declined further to about 1.99%. Why do investors appear to be confused by yesterday's developments?
Chairman's press conference
The Chairman's opening statement is intended to be consistent with the broad consensus on the FOMC and to provide a road map for the Committee's approach over the next few weeks heading into the next policy meeting, which will conclude on 18 September.
The Chairman's responses during the Q&A portion of the press conference were telling, and to our minds provide about as much clarity as possible given uncertainties and risks to the outlook and the institutional structure at the Fed, with a Chairman who tries to foster consensus among a large committee of policymakers (the FOMC) who hold a range of views.
During Q&A, the Chairman referred again to positive economic developments while emphasizing that yesterday's rate cut was intended as a type of insurance against downside risks, especially global in nature (including fallout from trade tensions). He introduced a new phrase — yesterday's cut should be viewed as a "mid-cycle adjustment to policy" and followed that by indicating that the cut should not be thought of as the first step in a "lengthy cutting cycle." However, he returned to themes of downside risks, a softening global outlook, and muted inflation, which are reasons to at least contemplate whether additional accommodation might be appropriate in the future.
One of the most salient comments came in response to a question from a reporter suggesting there was "a reluctance to provide more guidance around the future path of rates" perhaps because "that reflects a greater lack of consensus on the committee…" The Chairman agreed! This passage is telling and goes to the heart of yesterday's communication. Markets responded to the Chairman's remarks with confusion: will there be more rate cuts or not? What should markets price in with respect to the path of the funds-rate target beyond this meeting?
The explanation is relatively benign and not complicated: a solid majority of FOMC members, including the Chairman, believe it is appropriate to add a modest amount of accommodation on a risk-management basis to elevate the probability that the expansion will continue for the foreseeable future. They believe that a small amount of accommodation will not appreciably intensify the risk of overheating. However, some participants on the FOMC (including yesterday's dissenters, Rosengren and George, along with non-voters Barkin, Mester, and Harker) believe that risks would have remained appropriately balanced without yesterday's rate cut. The latter group are broadly comfortable with outlooks for real growth and inflation and are mindful of risks of overheating that could prompt a more aggressive policy response in the future and leave the economy more vulnerable to potential future adverse developments. When the Chairman speaks during the post-FOMC press conference, he is speaking for the Committee, so the nuanced and somewhat mixed messaging (as interpreted by markets) reflects the need to represent the diverse views of the Committee that can result in policy decisions driven by the need to compromise when forming a consensus. Unanimity is not required, but a broad consensus backed by a large majority is.
What is our outlook?
Yesterday's developments reinforced our outlook that a modest, 25 basis-point rate cut in July did not signal that future rate cuts are highly likely. Indeed, the combination of dissents and nuanced messaging from the Chairman support our base-case assumption that there will be no further rate cuts this year, and that barring a major downside surprise, yesterday's rate cut could be reversed in 2020 as the economy continues to grow at a broadly trend-like pace (or above) with strong labor markets and with a rise of inflation consistent with the Fed's 2% objective. As markets come to better appreciate that additional rate cuts are less likely, this will be a source of upside pressure on bond yields that are otherwise being pushed down in part by global forces, including negative bond yields in other regions such as Europe.
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