June 7, 2019

Fed Chair Powell and his colleagues are sending out strong hints that if growth slows as a result of the trade war the Fed is prepared to cut rates.  That is a dramatic turnabout from the Fed’s position in March.  Is that an accurate reading of the Fed’s intention?  If so, why the big change?  Would rate cuts even help?

Currently, the Fed pegs the funds rate in a range from 2.25-2.5%.  The December 2019 Fed funds futures contract stands at 1.71%, and the June 2020 contract at 1.49%.  So between now and this time next year the market expects the Fed to cut rates 3 times to 1.5%.   Fed Chair Powell indicated that the central bank was prepared to act to sustain the economic expansion if President trump’s trade war weakened the economy.  That is typical Fed-speak designed to send a message to the markets that the Fed is aware of the potential negative impact on the economy from tariffs and is prepared to act if necessary.  It should not be viewed as a signal that the Fed is convinced that its next move is to lower the funds rate.  While the Fed could act, of course, it will need a lot more data before it chooses to do so.

Some of his colleagues have explicitly indicated that they now believe rate cuts are necessary.  If this is an accurate reading of the Fed’s intentions that is a dramatic turnabout from what they concluded at the March FOMC meeting.  At that time they expected GDP growth this year of 2.1% (which is somewhat higher than the Fed’s expected potential GDP growth rate of 1.9%, and an increase in inflation (the core personal consumption expenditures deflator) this year of 2.0% – which would put it in line with its inflation target.  The Fed also indicated that it expected the funds rate to remain at its current level of 2.25-2.5% at the end of this year.  In March not a single one of the 17 Fed governors and Reserve Bank presidents called for a rate cut by yearend.  In fact, seven of the 17 members expected at least one rate hike during that period of time.

Given that view in March, are we to believe that the Fed has changed its mind and is now prepared to actually cut rates three times during the next year?  Our sense is that this is a gross misreading of the Fed’s intentions.  The next FOMC meeting is June 18-19 at which time we will get an update on the Fed’s GDP and inflation forecasts, as well as a revised path for the funds rate.

It is hard for us to imagine that the Fed has significantly reduced its GDP forecast for the year.  First quarter growth came in at 3.4% (far exceeding expectations and received subsequent to the FOMC meeting).  The second quarter consensus is for growth of about 1.5%.  That implies growth in the first half of the year of 2.5%.  No hint of any significant weakening in the pace of economic activity thus far.  Meanwhile the core PCE deflator is currently at 1.6%, but higher prices for imported products – from both China and now perhaps Mexico – should boost that rate of inflation very close to or slightly above the Fed’s 2.0% target by yearend.  Thus, the domestic economy does not seem to have deteriorated by any significant amount and inflation, if anything, seems likely to work its way higher. Perhaps the Fed has a different assessment.  We will soon see.

What does seem weak is economic growth outside the U.S.  For example, the World Bank recently reduced its projected global GDP growth rate for the year by 0.3% to 2.6%.  It maintained its projected GDP growth rate for the U.S. at 2.5% but cut growth almost everywhere else.  Europe was reduced 0.4%.  Japan by 0.1%.  Emerging economies were cut by 0.3% which included emerging economies in East Asia and the Pacific, Central Asia, Latin America, the Middle East, South Asia, and sub-Saharan Africa.

Why is virtually every country outside the U.S. having such a tough time?  Easy.  U.S. tariffs.  Global GDP growth is reduced by a trade war.  Everybody loses.  But trade is a mere 10% of the U.S. economy and roughly 50% elsewhere.  So while everybody loses, the U.S. gets hurt far less than everybody else.  Once global investors figured this out last year, foreign funds flowed into the U.S. and the dollar rose nearly 10%.  Emerging economies purchase raw materials to feed their manufacturing sector.  But those raw materials are all traded in dollars.  When the dollar rises it represents an increase in their cost of goods sold.  They are less able to compete in the global marketplace than they were previously.  Their currencies get crushed.  Their stock markets get clobbered.  In the end, GDP growth outside the U.S. – emerging countries in particular — is certain to slow.  That is what the World Bank just incorporated into its forecast.

But that raises a question.  If global growth is softening, how in the world does a rate cut in the U.S. solve that problem? First of all, it is unlikely to actually stimulate GDP growth.  Given that the economy is at full employment policy makers can only stimulate growth by boosting growth in the labor force or boosting growth in productivity.  With the unemployment rate at a 50-year low everybody who wants a job already has one.  It is hard to see how lower rates are going to boost growth in the labor force.  The labor force could also grow more quickly by increasing the number of immigrants.  But current policy seems likely to result in fewer immigrants entering the country, not more.  Growth in productivity is dependent upon business confidence and their willingness to invest.  But Trump’s erratic and unpredictable trade policy is generating uncertainty which could actually slow the growth rate of both investment and productivity.  Lower rates typically stimulate the pace of economic activity.  But with the economy at full employment and uncertainty rising that may not actually occur.

If lower rates stimulate consumer demand for goods and services GDP growth may not quicken but, in an effort to increase production, employers may boost wages to attract workers from other firms.  If the higher wages are not countered by a further pickup in the growth rate of productivity (which seems unlikely) inflation will rise.

Furthermore, it seems to us that lower rates are the wrong prescription for the problem.  A rate cut in the U.S. is not going to boost GDP growth outside of the U.S. – which is the root of the problem.  Growth outside the U.S. has been clobbered because of U.S. trade policy.  To solve that problem countries around the globe need to sit down with the U.S. and resolve their trade differences.  The most pressing problems at the moment are obviously the ones between the U.S., China, and Mexico.

Before we get too carried away with an expectation that the economy is falling off a cliff and desperately in need of lower interest rates, let’s see what actually happens.  We doubt that the economy will slow and inflation will sag as much as the market expects.  While the stock and bond markets can be leading indicators of what might happen in the economy, they often send false signals.  One does not need a long memory to recall the 20% decline in the stock market in the fourth quarter of last year which presumably foreshadowed an imminent slowdown in the pace of economic activity.  That theory was blown apart by the subsequent rebound in stocks and the 3.4% GDP growth rate in the first quarter.  This time it is the bond traders that are leading the charge and expecting an extremely pessimistic economic scenario to unfold.   We don’t believe the bond market’s view of the world either but, as always, time will tell.

Stephen Slifer


Charleston, S.C.