Global Daily – Why the Fed will still cut, despite stronger data

by: Bill Diviney

Fed View: Rate cuts are about risk management, not current conditions – Following yesterday’s better than expected macro data in the US, one question we have been getting is, has the Fed boxed itself into a corner by signalling so strongly to markets that it will cut rates, and might officials now regret that? While the doctrine of ‘data dependence’ would indeed suggest a lower likelihood of rate cuts, we think this misinterprets the Fed’s reaction function, and the reason for the shift to rate cuts. First, changes in monetary policy work their way through the economy with significant lags – a rule of thumb is 5-6 quarters on average, according to academic literature. As such, while recent data outturns are important, they are only one input into a range of factors that affect the central bank’s outlook for the economy – and it is the outlook that determines policy decisions. Second, and linked to this, the primary driver of rate cuts is the significant degree of uncertainty – linked to the trade war escalation – not the growth slowdown we saw earlier this year, in our view. An additional enabling factor for rate cuts is the persistent undershoot of inflation, and the risk of inflation expectations de-anchoring. Finally, the June FOMC projections showed a significant decline in the median neutral rate estimate, from 2.8% to 2.5%. This suggests that at least part of the desire to cut rates reflects a view that the Fed may have overtightened with the last rate hike in December. While the Fed will welcome the somewhat stronger tone to the data, therefore, it does not substantially change the balance of risks to the outlook – and as such, should keep the Fed comfortable on its rate-cutting path. We continue to expect a 25bp cut at the 30-31 July FOMC, followed by two further 25bp cuts by Q1 2020. (Bill Diviney)