The Federal Reserve chairman surprised the markets in his latest press conference on 1 May when he withdrew a significant part of the dovish rhetoric that has supported risk assets since early January.
Jay Powell’s main messages that day were that downside risks to the economy stemming from foreign economic events, notably in China, had diminished, and that recent low prints for core inflation were only temporary. Under repeated questioning, he refused to give any indication that a reduction in interest rates was even remotely under discussion.
Despite this, market sentiment remains extremely open to the possibility that the Fed’s next move will be to cut rates. In the latest Wall Street Journal survey of US economic forecasters, there is a small majority that believe the next move will be downwards and will occur before the end of this year.
Furthermore, futures prices in the Fed funds market show policy rates around 0.5 per cent lower by the end of 2020, which is 0.9 per cent below the median “dot” contained in the Federal Open Market Committee’s latest projections.
It, therefore, seems that the Fed’s cautionary tone about the next move in policy rates is not fully accepted by the markets. Why not?
There are two main factors influencing market sentiment: fears about the renewal of trade wars, and low incoming inflation data, relative to the developing framework for the Fed’s inflation target.
President Trump’s decision to increase the tariff levied on $200bn of Chinese imports from 10 per cent to 25 per cent is now being implemented. A further threat to impose tariffs on the remaining $325bn of imports, at 10-25 per cent, remains in the wings, and will take two to three months to implement.
The Fed’s initial reaction to this news is likely to be cautious and guarded. In recent speeches and minutes, the FOMC leadership has argued that the direct economic impact of the tariffs announced so far has not been very great. In particular, they have never pointed to the possible inflationary consequences of higher tariffs as a reason for changing monetary policy.
On growth, they have suggested that the direct impact on trade flows may be modest, but have warned about possible hits to business confidence, implying that a larger growth impact may become visible over a few quarters.
Independent estimates of the impact of all the additional tariffs under consideration tend to be bunched around an impact of about -0.4 per cent to US GDP, spread over two years, with an addition to US inflation of about 0.2-0.4 per cent over that period. The impact on Chinese GDP is usually shown to be two to three times larger than that in the US, without making allowance for adverse effects on business and consumer confidence, or any offsetting easing in macro policy.
These effects are probably manageable without any change in Fed policy rates, though forward guidance about policy biases could become more dovish. It would need a large and persistent decline in equity markets — say around 15-20 per cent — to tighten global monetary conditions enough to cause the FOMC actually to cut policy rates. This is likely to be seen as the last resort, for as long as unemployment remains far below equilibrium.
The second possible escape hatch from a more hawkish Fed is marked “low inflation”. There have been several successive downside surprises in both the core personal consumption expenditures index and the CPI.
Mr Powell was adamant in his press conference that these surprises have been caused by temporary factors, especially the decline in equity prices last year, which has reduced asset management prices in the inflation indices. He is clearly right about this, but the Fulcrum inflation models are now suggesting that the central bank’s 2 per cent inflation target will be missed by a full half point this year.
More importantly, the models are predicting a further inflation undershoot next year, since low inflation tends to be persistent. This could eventually reduce the Fed’s confidence that inflation is on target, especially if the target itself is effectively raised by changing the definition to a long-term inflation average after the review of the policy framework later this year.
Having said that, there is a very strong consensus on the FOMC at present that inflation is sufficiently close to target in the medium term to justify at least the current level of policy rates. That consensus is unlikely to change for quite a while.
The change in tone in Mr Powell’s press conference must surely have been carefully considered, given his earlier communications glitches. Only a very large fall in global equity prices would lead the FOMC to consider actual reductions in the policy rate. The Fed’s safety net for risk assets is some distance below current asset prices.
Recent inflation releases show US core PCE inflation running close to 1.5 per cent, well below the FOMC’s most recent forecast for the end of 2019. This shortfall will certainly be acknowledged at the committee’s June meeting. Although much of the recent drop has been due to transient factors, progress toward the 2 per cent “symmetrical” target may be slower than the FOMC expects next year.
On the trade war, the FOMC’s response will probably depend largely on the equity market.
According to Goldman Sachs, which has provided the standard indices of financial conditions widely used in the private sector for two decades, the global FCI in the developed economies has eased by 60 basis points since the beginning of 2019.
Two-thirds of this easing has been due to the rebound in equity markets, much of which has probably been triggered by earlier perceptions of progress in trade talks between the US and China. Any long-term setback in the trade talks could lead to a tightening in the FCI, which could cause the Fed to consider rate cuts.