The bond market has already priced in cuts later this year. Though possibly ahead of itself in terms of timing, the market’s call on the direction of rates looks right, notes Western Asset’s John Bellows.
There have been a number of crosscurrents in recent communications from the Fed. Fed officials have expressed concern about the long-term outlook, optimism about the short-term outlook, and a heightened sense of caution about downside risks. This paper puts each of these distinct themes in its proper context, and then provides two key conclusions that we think will drive market pricing for the remainder of the year. We think the odds favor a Fed rate cut at some point, and we think the risks to monetary policy are asymmetric toward lower yields.
- The Fed’s focus on low inflation as the “major challenge of our time” provides a distinctly dovish backdrop for monetary policy. This is a long-term concern and is appropriate.
- In contrast to long-term concerns, the Fed has been optimistic about the short term. Later this year the Fed’s optimism could be challenged by lower-than-anticipated inflation or growth, or increased trade-related tensions.
- The Fed will cut rates when it is concerned about both the short-term and the long-term outlooks. We think the odds favor some development pushing the Fed to cut rates later this year.
- The market is already priced for cuts later this year. The market may be ahead of developments, but, in our view, has the direction of risks correct.
There are a lot of crosscurrents in the outlook for monetary policy. The Federal Reserve (Fed) is worried about the long term, optimistic about the short term and closely monitoring downside risks. On any given day one message or another could dominate the news, making it extraordinarily difficult to follow exactly what the Fed is trying to communicate.
The futures market for overnight interest rates is currently pricing 1.74% at the end of this year and 1.51% at the end of next year. This is 0.64% and 0.87%, respectively, below the current level of overnight interest rates, and would be consistent with the Fed cutting interest rates at least two times this year and then once more next year. Given this pricing, it is understandable that investor focus has shifted to the conditions required for the Fed to initiate an easing cycle.
This paper outlines our view on what it would take for the Fed to cut rates. The Fed’s focus on low inflation as the “major challenge of our time” provides a distinctly dovish backdrop for monetary policy. The recent developments in the trade conflict give the Fed an immediate and tangible threat that could justify a rate cut, much as the crises in Mexico and Russia pushed the Fed to cut rates in 1995 and 1998, respectively. The only thing standing between the Fed and a rate cut is the short-term optimism that the Fed has held onto so far. There are a number of ways in which that short-term optimism could be replaced with short-term concern, ranging from softening growth and inflation data to increasing trade tensions. While it’s hard to say which one could put the Fed over the edge, we think the odds favor some development pushing the Fed to cut rates later this year.
“The Fed is right to pay attention [to stubbornly low inflation.]”
While we think at least one cut is likely, there are also clear ways in which that might not materialize (e.g., resolution on trade, better-than-expected growth). In any event, the backdrop of heightened concern about low inflation (and the dovish policy bias that it implies) is likely to remain in place for the foreseeable future. That is likely to keep the risks for yields on the front end of the curve asymmetric toward the downside, and is likely to keep the front end of the yield curve inverted. The market may be somewhat ahead of developments in anticipating multiple cuts this year and next, but, in our view, it’s certainly got the direction of risks correct.
The Long-Term Outlook: Low Inflation Is a “Major Challenge”
“[Below target inflation] is a major challenge. It’s one of the major challenges of our time, really, to have inflation—you know, downward pressure on inflation, let’s say.”
-Jerome Powell, March 20, 2019
The Fed’s renewed focus on inflation has been a significant contributor to lower yields this year. In March, Fed Chair Jerome Powell called low inflation a “major challenge.” With these comments he joined a growing chorus of Fed members focused on low inflation and engaged in a search for potential remedies.
It’s not hard to see why Powell and others are concerned. Trends in demographics and debt burdens provide stiff headwinds for inflation, as Japan’s protracted experience of flirting with deflation clearly illustrates. Low inflation limits central banks’ ability to support the economy in a downturn. For example, the European Central Bank has struggled to stimulate growth in the eurozone, in part due to low inflation limiting how much real rates can fall. Persistently below-target inflation also raises uncomfortable questions about central banks’ efficacy and credibility. This is an issue that all central banks are facing.
None of these issues should be coming as a surprise. (Indeed, our own research notes have discussed each one as we have repeatedly flagged the persistence of low inflation over the last few years.) The Fed is right to pay attention, albeit somewhat belatedly.
It’s important to note that these concerns are mostly long-term issues for the Fed. The Japanese experience highlights the risks associated with aging and debt, but the US is still many years away from facing an outright population decline or levels of debt comparable to that of the Japanese. The Fed is concerned about how it will cope with the next recession, even though it expects that the next recession is still a way off. And while all central banks are worried about maintaining credibility, generally speaking, developed market central banks have managed to maintain their independence and sway over the market.
“In contrast to the long-term concerns, the Fed has remained relatively sanguine about the short-term outlook.”
The Short-Term Outlook: Is Low Inflation “Transitory”?
“Core inflation unexpectedly fell as well, however, and as of March stood at 1.6 percent for the previous 12 months. We suspect that some transitory factors may be at work. Thus, our baseline view remains that, with a strong job market and continued growth, inflation will return to 2 percent over time and then be roughly symmetric around our longer-term objective.”
-Jerome Powell, May 1, 2019
In contrast to the long-term concerns, the Fed has remained relatively sanguine about the short-term outlook. Chair Powell made this abundantly clear in the press conference following the May Federal Open Market Committee meeting, when he dismissed the recent low inflation as “transitory,” then reiterated the Fed’s optimistic outlook that inflation would return to 2% by the end of the year. Powell’s previous discussion of consequences of low inflation was nowhere to be found, and in its place was renewed confidence in the outlook for firming inflation.
The disconnect between Powell’s comments in March, when he referred to low inflation as a “major concern,” and his comments in May, when he dismissed falling inflation as “transitory,” was jarring. Making Powell’s about-face even more puzzling was the fact that in the interim the Bureau of Economic Analysis released inflation data that surprised to the downside, putting the Fed even further from meeting its objective.
How can the two sets of remarks be reconciled? How can Powell be concerned about low inflation one month and relaxed the next? One way to reconcile the remarks is to understand that they are in reference to different time scales. The concerns are centered primarily on the long-term issues, while the optimism refers to the short term. Stated differently, while the long-term outlook for inflation is worrisome, the “long term” is at least a few more quarters away, and until then everything should work out fine. At least that seems to be what the Fed believes.
Not only does the Fed’s rhetoric in speeches appear to be contradictory at times, the juxtaposition of long-term concern and short-term optimism makes it difficult for investors to assess the probability of Fed action. One day it seems like the Fed is worried enough about the long term to cut rates, while the next day Fed officials are expressing confidence in the short-term outlook and in their current policy stance. The confusion could continue for some time to come. The difference in time scales is a nuanced message, and it is often unclear when the long-term considerations have short-term implications, or vice versa. This is just confusion investors will have to live with.
“... in a backdrop of sluggish growth and low inflation, the emergence of a specific threat — one that is salient, potentially large in magnitude, and could be international in nature — can tip the Fed toward easing.”
Risk Management: Threats to the Outlook
“We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective.”
-Jerome Powell, March 20, 2019
More recently the issue of downside risks has reemerged in comments by Fed officials. The issue of downside risks is always present, of course, but occasionally moves up to the fore due to developments or headlines. The latest catalyst has been the escalating trade dispute with China (and, briefly, the prospect of higher tariffs on Mexican imports). These trade-related developments have made the downside risks concrete and immediate, and by doing so have given the Fed an excuse to cut rates, should it decide to do so later this year.
Much has been made of the Fed’s “insurance cuts” in 1995 and 1998, with the implication being that the Fed’s playbook could be repeated this year. The analogy to the 1990s may in fact prove useful, but first a caveat is in order.
Those cuts are often cited as examples of when the Fed acted pre-emptively, taking out some policy “insurance” in order to shore up the long-term outlook. It is true that these cuts took place during periods of slowing growth and lower-than-anticipated inflation. Slower growth and inflation, however, were not really the main motivators of these cuts. A closer look at those two episodes suggest they were really direct responses to imminent short-term threats. In 1995 concerns about Mexico—which was in the midst of a currency and financial crisis that was caused, in part, by the Fed’s hiking campaign the year before—dominated the Fed’s discussion and played an outsized role in motivating the cut. Similarly, the Fed cut in 1998 was in direct response to the upheaval in certain emerging markets, notably Russia, which was affecting levered investors in the US and had the potential to do much wider damage to the global economy. In both cases the Fed was responding to an immediate threat, rather than acting out of concerns about the long-term trajectory of growth and inflation.
The lesson from the 1990s, then, is as follows. In a backdrop of sluggish growth and low inflation, the emergence of a specific threat—one that is salient, potentially large in magnitude, and could be international in nature—can tip the Fed toward easing. In both 1995 and 1998 the emergence of a short-term threat worked to focus the Fed’s collective mind and nudge the Fed into action. In this sense, the recent trade-related developments do indeed make the analogy to the 1990s compelling, and in doing so heighten the case for a rate cut sometime this year.
Bottom Line: A Fed Cut Is More Likely Than Not; The Front Part of the Yield Curve Will Stay Inverted
This mix of considerations—long-term concern, short-term optimism and risk management—can indeed be confusing. Over the last few weeks the market has focused on the risk management perspective, but that could turn around or another theme could rise in prominence. As we look forward, we think there are at least two concrete conclusions that will continue to guide market pricing, regardless of the day- to-day headlines:
1. Rate Cuts Will Come When Short-Term Concerns Replaces Short-Term Optimism
As Powell made clear in his May comments on the case for short-term optimism, the Fed does not appear inclined to cut rates based on the long-term concerns alone. In our view, it will likely require a deterioration in the short-term outlook to compel the Fed to cut rates. To put it even more bluntly: the Fed is only likely to cut rates if it is concerned about both the short-term and long-term outlooks.
A more marked shift toward short-term concern could be triggered by any number of possible developments. For instance, further downside surprises in incoming price data could force the Fed’s hand with respect to inflation. Wage growth appears to have plateaued. Even more worrisome is that the rate of growth of personal income has been on a downward trajectory since late last year. Recent data on real economic growth have hardly been more encouraging. In addition to the widely followed nonfarm payroll data, which showed a disappointing 75,000 jobs created in May, the data on retail sales and industrial production have also been weaker than anticipated. Further disappointments on either inflation or growth could work to change the minds of some Fed officials.
The prospect of a prolonged trade dispute also raises the risks to US growth. As we have discussed, higher tariffs don’t really raise concerns about inflation, because any period of faster inflation due to tariffs is likely to be temporary. But tariffs will weigh on demand, and also pose risks for business sentiment and financial conditions. On net, the downside risks related to trade will outweigh any positive from a temporary boost to inflation.
“The asymmetry in probabilities means that yields are likely to trade below the fed funds rate for the foreseeable future. In other words, the very front part of the yield curve should stay inverted in the current environment.”
It’s important to note that the softness in growth and inflation data is still in its early stages, and the outlook for the trade conflict is still very uncertain. Nonetheless, it’s easy to imagine that over the course of the next six months a string of disappointing data releases, or a further setback in trade negotiations, could cause the Fed to waver in its short-term optimism. When that happens, the Fed will follow through on its commitment to act as necessary in order to shore up the recovery. We think that the odds favor such a move sometime between now and the end of the year.
2. The Prevalence of Long-Term Concerns Make the Chances of a Fed Cut Asymmetric, Keeping the Yield Curve Inverted
The long-term concerns are starting to appear in more places than just obscure Fed speeches. For example, the Fed’s strategy review and “Fed Listens” events, which culminated last week with a research conference in Chicago, will eventually lead the Fed to adopt an average inflation targeting (AIT) strategy. The new strategy will require the Fed to explicitly aim for inflation above 2% during expansions in order to compensate for the high likelihood of inflation falling below 2% during recessions. While the new target for inflation during expansions won’t be dramatically higher—perhaps around 2.3%—nonetheless this will be a concrete step. It’s too early to tell whether such a change will matter for long-term outcomes. We have our doubts.
What is clear, however, is that in the current environment the new AIT strategy makes rate cuts more likely than rate hikes. This is a straightforward implication of the higher target for inflation, combined with the fact that inflation is currently running below 2%. Specifically, currently core inflation is running around 1.6%. In order for the Fed to raise rates, core inflation would likely need to rise to the Fed’s new target—which the AIT puts at around 2.3% during an expansion—and threaten to move still higher from there. Such an outcome is a very long way away. On the other hand, an unexpected fall in inflation could heighten concerns about low inflation, which could trigger a Fed rate cut. While the exact level that would trigger a cut is unknown, it has to be the case that currently inflation is closer to that level than it is to the 2.3% level needed to justify a rate rise. It follows, therefore, that the Fed is closer to cutting rates to support inflation than it is to hiking rates to contain inflation.
Market prices reflect the weighted average of the various scenarios. The asymmetry in probabilities means that yields are likely to trade below the fed funds rate for the foreseeable future. In other words, the very front part of the yield curve should stay inverted in the current environment.
At its upcoming meeting the Fed is unlikely to make any changes to policy or any firm commitments for the second half of the year. There is too much uncertainty and the Fed’s short-term optimism is too entrenched for the majority of the committee to back a concrete move right now. What is more likely is that the Fed will carefully lay the groundwork for a subsequent move, should events unfold in a way that one would be justified. This could be accomplished by amplifying Powell’s message on downside risks—including the words “carefully monitoring” and a commitment to “act as appropriate.” An alternative would be to further emphasize the low inflation backdrop and the need to get inflation higher over time. The specifics are less important than the message, which will be that the Fed stands ready to ease policy and will act as necessary to sustain the recovery.
Our view, as laid out here, is that such a move will in fact prove necessary sometime this year. At a minimum, inflation is stubbornly low and could yet fall further. Any weakness in growth or increase in trade tensions could also motivate a cut. The odds favor at least one such development.
Of course the market is already priced for a rate cut, and in fact is priced for much more. This may prove to be ahead of developments, as the current pricing anticipates a much more negative outcome for growth and inflation than we expect. That said, the dovish backdrop for monetary policy creates clearly asymmetric risks to the downside for yields. So, while the market may be slightly ahead, it clearly has the direction of risks correct.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.
Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.