A Fed Rate Cut This Week Won't Be the Start of Trend
(Bloomberg Opinion) -- The U.S. Federal Reserve this week will take out insurance on the decade-long economic expansion and cut policy rates by a quarter of a percentage point on Wednesday. Weak business investment highlights the need for such insurance, while the solid consumer picture suggest that half a percentage point would be too much.
The Fed isn’t viewing this event as the beginning of a sustained easing cycle just yet, so more rate cuts aren’t guaranteed. A firming of business investment would take future reductions off the table after the economy expanded at a 2.1% annualized rate in the second quarter. That compares with central bankers’s 2019 estimate of 2% to 2.2% and begs the question of whether or not the data flow in general supports a rate cut.
The Fed has largely avoided defending this week’s likely rate cut on the basis of the data. It’s primarily about risk management and a recalibration in response to rising risks associated with global growth and trade tensions. The fear is that these factors will materially affect U.S. business investment (nonresidential investment fell 0.6% in the second quarter to mark its first decline since 2016) and threaten to soften activity at a time when the Fed has been struggling to maintain inflation at the 2% target. That’s why this week’s move is seen an insurance cut to stay ahead of such risks.
The soft showing of business investment in the second-quarter GDP report will help convince the Fed that the risks to the economy are real and that a 25-basis-point reduction in policy rates is needed. It is not, however, sufficient to turn the Fed’s attention to a larger rate 50-basis-point cut. A weak GDP number had been expected, so it wasn’t a surprise. Note also that consumer spending rebounded from a poor showing in the first quarter and the persistently low level of initial unemployment claims indicates that the labor market remains solid, which should sustain consumer spending. Final sales for private domestic purchasers grew 3.2%, almost on par with the 3.3% of 2018.
It is easy to see why Fed Vice Chairman Richard Clarida echoed his colleagues in describing the economy as in a “good place.” A 50-basis-point cut would be dramatic for an economy in a “good place” and no one on the Fed board believes they are on the cusp of a period of substantial rate cuts. The desire for lower rates isn’t universal among policy makers. At the last Fed meeting, about half the participants expected rates to hold steady this year while the other half expected rates to fall by 50 basis points. I believe the Fed will gain consensus on a 25-basis-point cut this week with the hawks expecting that future rate reductions will increasingly require deteriorating data or an intensification of risks to the forecast.
This set up will leave Fed Chairman Jerome Powell walking a bit of a tightrope in the press conference following the decision. Powell will be wary of sounding too dovish and raising expectations for a future rate cuts that future data won’t support (the Fed already let expectations of a 50-basis-point reduction get out of hand, as illustrated by the reaction to a recent speech by New York Federal Reserve President John Williams). At the same time, Powell doesn’t want to sound too hawkish and risk a repeat of the financial turmoil that followed the December Fed meeting. He won’t want to sound as if this cut will be quickly reversed.
I expect Powell to thread the needle by emphasizing future policy changes will follow actual data and risks to the outlook with the intention of sustaining the expansion. Looking beyond this week’s meeting, this means that the Fed has not committed to anything more than 25 basis points at this time. If neither the data improves nor the risks to the outlook dissipate, the Fed doves will likely be able to make the case for another 25 basis points in September. Beyond that, I expect further cuts will require a broader deterioration in the data or an intensification of the risks. Pay particular attention to business confidence and investment. If firms shake off their second-quarter blues, the Fed will be hard pressed to continue with additional rate cuts.
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Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
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