summary
  • The Fed’s Dilemma
  • Mario Draghi Solidifies His Legacy
  • The Renewed Rush to Refinance

The Federal Open Market Committee (FOMC) meets next week, and it will be a highly anticipated gathering. Futures markets and Fed watchers are certain of a rate cut, but the path of the Fed Funds rate thereafter is a subject of much debate. Here, in the equivocal fashion favored by economists, are the arguments on both sides.

On the one hand, why might the Fed wait to cut rates further?

Employment is strong. The Federal Reserve has a dual mandate to maximize employment and maintain stable prices. The U.S. employment picture has been rosy, with the unemployment rate holding at 3.7%. Job creation cooled in August but remains healthy for an economy a decade into an expansion cycle.

Consumer spending continues unabated. Consumers were the bright spot of the second-quarter gross domestic product (GDP) estimate, outperforming amid an otherwise mixed picture. Personal consumption expenditures grew at a healthy 4.2% year-over-year pace in July, suggesting continued momentum going into the third quarter. We hold out hope that the sudden drop in the University of Michigan Consumer Sentiment Index in August was a one-month aberration, not the start of a trend.

Weekly Economic Commentary - 9/13/19 - chart 1

Interest rates are low. Consumers and corporations alike are finding that credit is available and affordable. The cost of financing is not a deterrent to investment. Credit spreads (the yield on corporate bonds relative to risk-free government bonds) remain low, a sign of high liquidity and low risk in fixed income markets. Taken together, these developments produce easy financial conditions.

With growth balanced across sectors, asset bubbles are not a worry at the moment. We would like to keep it that way. Low rates can lead to speculative investments into riskier asset classes as investors reach for yield. The Fed is intent on sustaining financial stability.

“Central banks cannot ignore trade conflicts, but cannot do much to mitigate them.”

And the Fed must be careful about the signal that would be sent by an aggressive string of rate cuts. This would quickly take it from a mid-course correction (the rationale for July’s action) to something more panicked. If the Fed appears nervous, fear may be contagious.

On the other hand, why might the Fed cut more aggressively?

Trade and global market risks continue to grow. In the July press conference, Fed Chair Jerome Powell consistently emphasized that the Fed was acting to support the expansion against the risk that trade tensions would cause a global slowdown. Since then, those risks have only increased, starting with an escalation of U.S. tariffs on Chinese imports the day after the Fed meeting. While negotiations are back on for next month, hopes are not high for a broad resolution.

Business spending has slowed. Estimates of second-quarter gross domestic product saw a decline in business investment, a sign of elevated uncertainty. This month, the U.S. manufacturing Purchasing Managers’ Index (PMI) fell to 49.1, the first sign of contraction in over three years. And in the near future, the effects of fiscal stimulus, particularly the Tax Cuts and Jobs Act of 2017, will fade. A lower-rate environment can help to offset the loss of momentum.