Investments

How Likely is the Fed to Cut Interest Rates?

By Shane Barber

June 21, 2019

The question of the day is, how likely is the Fed to cut interest rates in the near term?

Interest Rate Changes and Market Movement

Their rhetoric has certainly picked up. Last year’s rate hike in December—seen by many as a “mistake” was a continuation of the normalization of monetary policy that began in 2016. This is in contrast to the Fed’s sharp about-face not two months later, where rate hikes were effectively put on pause. The newly dovish tone from the Fed helped fuel the equity rally of the first quarter as interest rate expectations are increasingly important to the markets. Speculation about the Fed’s future moves has been in a first-place tie with global trade policy as the key market driver this year.

Policy communication, or formally, ‘forward guidance,’ is an essential part of the modern central banker’s toolkit. Used by the FOMC and ECB especially, a single word (like ‘patience’ earlier this year) can move market sentiment sharply in either direction, which is why every Fed speech and comment is parsed so diligently. Contrast this to years past where opaqueness was the norm, think Alan Greenspan and irrational exuberance. Fed meeting outcomes had to be interpreted through changes in Treasury bond trading after the fact.

So… How Likely is the Fed to Cut Interest Rates in the Near Future?

In reality, the Fed hasn’t said much that we don’t already know. In recent weeks, the statement that they stand ready to ‘support the economy’ was interpreted as the bar for a fed funds rate cut being lowered; however, supporting the economy is something the Fed sees as a primary function continually. While some politicians prefer to see a Fed with their foot on the gas—keeping rates low to keep economic expansions intact—the role of central banks is to take an independent, detached view of economic cycles. The Fed’s key mandates from the beginning have been:

  1. Maximizing employment,
  2. Stabilizing prices (i.e. inflation)
  3. Moderating long-term interest rates

Since interest rates are generally tied to inflation levels, the first two represent the oft-quoted dual mandate. General economic stability is an implied goal as well, but only as a means to accommodate the primary mandates.

Employment

In reviewing the current status of these goals distinctly, employment is as strong as it’s been in several decades. By some measures, since the late 1960s. Changes in labor markets move relatively slowly in normal environments. Due to this, data such as a steady deterioration in the unemployment rate or persistently rising jobless claims would offer clues to worsening labor trends. Other than perpetually below-expected labor force participation, due to a variety of perhaps societal and technological factors, employment looks relatively strong by almost all counts. Lowering interest rates to stimulate ‘better’ employment at this level would be a tough sell.

Inflation is also well-controlled. In fact, core inflation, which removes the dramatic price noise of energy and food, has been remarkably close to the target 2% level for years, although it’s dipped a bit below that recently. Central banks, and especially the Fed, are wary of chronic deflation taking hold, which can be a challenging paradigm to escape. However, they’ve communicated that being a few tenths of a percent above or below that 2% level is well within their target range (implying it’s fruitless to fine-tune levels tighter than this). So, with inflation at target, leaving rates at current levels could seem more appropriate than a movement up or down based on that mandate.

International Concerns

There are, of course, other concerns. The U.S.-China trade negotiations seem to be in a more precarious position than they were in prior months. Also, higher tariffs for a longer period could slow global growth and pressure many central banks to ease. This raises the odds of a ‘preemptive strike’ rate cut. This kind of preemptive move may be more difficult to justify until the data turns negative. But this wouldn’t be the first time the Fed has implemented a rate change on that rationale. The results of the meeting between Xi and Trump at the G-20 summit will either remove this as a valid concern or give further rationalize the Fed to cut interest rates.

On Wednesday, June 19, Federal Reserve Chairman Jerome Powell said, “The case for a somewhat more accommodative policy has strengthened.” In layman’s terms, he’s saying that the Federal Reserve is considering cutting interest rates. Historically, when the economy is strong and expanding, the Federal Reserve will generally raise rates to keep the economy from “overheating.” When things slow down economically, we can expect the Fed to cut interest rates, hoping to jump-start borrowing and other economic activity.

In Conclusion

The fact that the Fed is considering a cut to interest rates could be a telling sign that monetary policymakers feel as though the economy is cooling off. The last two times the Federal Reserve started a declining-rate policy (in January 2001 and in September 2007), the United States entered into recession within three months. It’s important to note that if the Fed were to cut interest rates, it does not create a recession. However, it does signal that the Fed is concerned about slowing growth.

Take a look at the chart below:

Fed to Cut Interest Rates - TFF Rate Lower Limit vs. S&P 500

Source: ycharts.com

(The shaded darker gray areas represent recessions.)

The Federal Reserve will meet next on July 30. Many believe that a rate cut may result from the meeting, barring consistently good economic data between now and then. Eight fed officials expect by the end of the year that we’ll see a rate cut.

While this new development doesn’t mean we are heading towards a recession, it is certainly worth paying attention to.

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The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.