July 19, 2019

Over the next two weeks we will learn a lot about GDP growth and how Fed policy might be implemented in the months ahead.  No matter what the Fed does at month end its credibility is at stake.  And, depending upon the outcome, our view of the economy’s long-term speed limit could be affected.

At the March 20 FOMC meeting the Fed said it “continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective as the most likely outcomes”.  On June 19 it said the same thing, but added “uncertainties about this outlook have increased”.  At both meetings it indicated that future changes in the federal funds rate would be data dependent.

Furthermore, at the March 20 meeting not as single member of the FOMC expected a rate cut by the end of the year.  In fact 6 of 19 members expected rates to be higher by yearend.  At the June 19 meeting 8 of 19 members thought rates would be lower by yearend.  That is a dramatic shift in Fed thinking in a 3-month period of time.  The only thing different between the two Fed statements is that uncertainties have increased.  What happened?

In the 3-month internal between meetings the economic data showed no evidence of a slowdown.  Employment gains have averaged 170 thousand.  Retail sales have been robust.  Following 3.1% GDP growth in the first quarter most economists anticipate Q2 growth of 1.5%.  That implies growth in the first half of the year of 2.3%.  But the Fed believes potential growth is 1.8%, so in the first half of the year the economy presumably grew faster than the speed limit.  That provides no justification for lower rates.

Similarly, the Fed’s inflation rate stands at 1.6% relative to the Fed’s target of 2.0%.  But it has not fallen any farther below that goal in recent months and most economists – including those at the Fed – expect it to approach the 2.0% target by yearend.  Once again, no justification for lower rates.

If the Fed cuts rates, its statement that future changes in the federal funds rate will be “data dependent” will have disappeared.  So much for Fed credibility.

Given that the domestic economic data remain robust, the uncertainty that the Fed perceives must be related to slower growth overseas.  That is an accurate assessment and readily apparent in both China and Europe.  But with U.S. GDP of $20 trillion, the E.U. economies collectively at $18 trillion, and China at $13 trillion, does the Fed seriously believe that a rate cut in the U.S. will significantly boost growth in either of those areas?  That is a reach.

Or perhaps the Fed believes that growth in China and Europe will significantly curtail U.S. GDP growth in the second half of this year.  But with trade only being about 10% of the U.S. economy, economic woes in Europe and China are extremely unlikely to significantly dampen GDP growth in that period of time.  That also seems to stretch credibility.

All of the Fed’s chatter about economic uncertainty and the possibility of slower GDP growth ahead have fueled expectations for several rate cuts by this time next year.  The June 2020 Fed funds rate futures contract expects that rate to be 1.5% then versus 2.25-2.5% currently.

If there was any chance that the FOMC would not cut rates at the end of this month and that the market was getting ahead of the Fed, Fed officials have had ample opportunity to counter that view.  Instead, a long list of Fed officials have added fuel to the fire by talking about a need for the Fed to act quickly if the U.S. economy looked likely to stumble.

So, what might happen in the next couple of weeks?  Second quarter GDP growth rate will be released on Thursday, July 26.  Suppose everybody is wrong and GDP growth declines by, say, 0.5%.  That seems unlikely, but if it were to happen GDP growth in the first half of the year would be 1.3% and the Fed’s urgency to cut rates would be understandable.  To us, an unexpectedly soft GDP reading in the second quarter is the only justification for an immediate cut in the funds rate.

But suppose second quarter GDP growth is in line with the expected 1.5%.  The Fed will be in an ever bigger bind.  A rate cut would not be justified given the lengthy string of respectable economic indicators.  But given the widespread belief that the Fed will cut rates by either 0.25% or 0.5% on July 31. no rate reduction would trigger an impressive selloff in both the stock and bond markets.  Furthermore, its market guidance will have been terrible.  Fed officials strongly suggested one outcome – a rate cut — but did something entirely different.

Other consequences of a rate cut could be even worse.  While the Fed may have given the right signal about its intention to cut rates, its stated intention that future action would be “data dependent” goes out the window.  With economic growth in the first half of the year of 2.3% and no hint of slower growth in the third quarter, a rate cut would clearly not be data driven.  Thus, the Fed’s credibility is at stake.

Worse yet, if the Fed cuts rates the president will gleefully point out that he told the Fed not to raise rates back in December and that he was right and the Fed was wrong.  Rightly or wrongly, some market participants will conclude that the Fed’s action was politically motivated.  Any hint that the Fed’s independence has been compromised will do irreparable damage to its credibility.

Finally, a rate cut now will only encourage the markets to anticipate additional rate cuts in the months to come.  Hedge funds and large money managers will feel free to speculate about future rate cuts and likely be rewarded because the spineless Fed would be unwilling to tolerate a significant negative market reaction.

This is as important a moment for the markets and the economy as we have experienced since this expansion began a decade ago.  If the Fed is unable to maintain its credibility, uncertainty will increase dramatically, business people will curtail investment, and the rosy outcome that we expect for the next several years will be at risk.  Rather than a pickup in the economic speed limit to 2.8%, our estimate of potential growth may have to be reduced by some amount.  The next couple of weeks are important.  Lousy fiscal policy (in the form of higher tariffs), followed by lousy monetary policy (in the form of heightened uncertainty about future Fed action) could alter our view of the world.

Stay tuned.

Stephen Slifer


Charleston, S.C.