The Final Cut … or More to Come?
The Fed cut rates by the expected 25 basis points, with a split in sentiment from FOMC members; as well as three dissents.
The interest on excess reserves (IOER) was cut by a larger 30 basis points to address the liquidity problems in the repo market.
Stocks were weak and bond yields rose as the decision was seen as a bit more hawkish than what some investors had been expecting.
As expected, the Federal Open Market Committee (FOMC) cut the fed funds rate by 25 basis points to a target range of 1.75% to 2.00%; which was the second rate cut this year. They maintained their pledge to “act as appropriate to sustain the expansion.” There were three dissents: Kansas City Fed chief Esther George and Boston Fed chief Eric Rosengren dissented again, as in July, preferring to keep rates unchanged; while this meeting brought an additional dissent from St. Louis Fed chief James Bullard, who preferred a 50 basis points cut. Three dissents in a Fed decision is a first since 2016.
In terms of the “dots plot” representing individual expectations, the committee was split as to whether there will be need for additional easing. Five FOMC officials wanted to keep rates unchanged today and through the rest of this year; five saw a quarter point cut as necessary, then keeping them there for the rest of the year; and seven pushed for 50 basis points in cuts this year.
The uncertainty lies with the competing forces of the negative effects of the ongoing trade war and weak global growth, and the relative strength of the consumer side of the U.S. economy. On that note, the statement included the following: “Although household spending has been rising at a strong pace, business fixed investment and exports have weakened.”
The FOMC also released new quarterly forecasts:
- The median estimate saw the fed funds rate holding steady after today’s move, at 1.9%; and remaining there until the end of 2020, thereafter rising to 2.1% in 2021 and 2.4% in 2022.
- The unemployment rate was forecast to end this year at 3.7% (up 0.1% from June) and finish 2020 at that same level; while the longer-run estimate was unchanged at 4.2%.
- They continue to forecast that inflation won’t reach their 2% target until 2021.
There were limited changes to the FOMC’s statement, which continues to signal optimism but also concern about downside risk due to “uncertainties.” The only change of note was the addition of a reference to weaker exports in the sentence that referenced weak business fixed investment.
In addition to the reduction of the fed funds rate, the interest rate the Fed pays on excess reserves (IOER) was cut by 30 basis points amid a breakdown this week in the overnight repurchase lending market. Repurchase agreements (“repos”) are a way to finance purchases of Treasuries or agency government securities by institutional buyers like investment managers, banks or hedge funds; with the Fed influencing the repo rate.
Funding market have been tight for quite a while and there have been problems from time to time getting the funding needed to finance bond purchases. This has been exacerbated by the rise in the budget deficit and related increase in Treasury issuance; but also by the timing of corporate tax payments and heavy corporate bond issuance. One of the consequences is that the shortage of liquidity pushed up the upper end of the fed funds rate, so that the effective fed funds rate (EFFR) moved above the Fed’s target band.
Under normal circumstances, the New York Fed steps in with temporary open market operations—which is what they did yesterday, providing $75 billion to the market. More will likely need to be done to address the issue, including today’s reduction in the IOER, which will encourage more money to go into the system. The Fed could also opt to increase the size of its balance sheet to add more reserves to the system—but importantly, this would not be quantitative easing (QE). It would be more of a technical fix. In fact, for most years from the inception of the Federal Reserve more than a century ago, until the onset of the global financial crisis, the Fed added assets to its balance sheet to meet the growth in demand for its liabilities.
Fed chair Jerome Powell used his opening statement to emphasize that the economy “continues to perform well” and that the “baseline outlook remains favorable;” while also highlighting increased “uncertainty” due to the trade war and weak global growth, still-low inflation, and the desire to take out some “insurance.”
Powell fielded a few questions about negative rates globally and whether the Fed would ever head down that path. In response, he noted: “I do not think we’d be looking at using negative rates; I just don’t think those will be at the top of our list.” Instead, he suggested: “If we were to find ourselves at some future date again at the effective lower bound—again, not something we are expecting—then I think we would look at using large scale asset purchases and forward guidance.”
The reaction by U.S. stocks (as of this writing) was a fairly swift sell-off, while the 10-year Treasury yield and the U.S. dollar both got a lift; likely due to the perception that the meeting’s results were a bit more hawkish than expected. Looking ahead, the path for stocks is likely to be tied to the state (or stage) of the economic expansion.
Historically, stocks have performed well in the year following a second rate cut—perhaps as it demonstrated the Fed’s commitment to easing. In most historical cases though, the Fed waited until near the end of recessions before cutting. When the Fed began to cut near the start of recessions, the second cut didn’t help much. As it doesn’t presently look like a recession is underway, the historical analogs provide two distinctly different outcomes.
According to Ned Davis Research and using the Dow Jones Industrial Average, which has a longer history than the S&P 500, since 1921:
- When the economy avoided recession in the subsequent year (seven historical cases), the Dow had an average gain of 18.2% in that year.
- When the economy entered a recession in the subsequent year (12 historical cases), the Dow had an average loss -10.8% in that year.
We continue to recommend investors stay close to their strategic equity allocations and limit bets in either direction. As noted by Powell, trade continues to be an important factor in gauging the trajectory of the economy from here. For now, there is a fairly firm dividing line between the beleaguered manufacturing side of the economy and the healthier consumer side. The likely transmission mechanism for the former morphing into the latter is through the employment channel—one of the Fed’s two mandates. That remains key to watch between now and the next FOMC meeting.
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