Today’s FOMC announcement reinforced market expectations that the Fed will cut rates in 2019. Looking ahead, we think the market’s positive reaction to the Fed’s newfound appetite for rate cuts is shortsighted. We see increasing risk that the Fed is actually adding to market uncertainty instead of offsetting it, a situation that could ignite significant volatility.
The FOMC loses patience
The FOMC held the Fed funds target band unchanged at 2.25%–2.50%, as expected, and left its 2019 growth forecast unchanged at 2.1%, although its statement stressed increased uncertainties to its outlook. The median Fed funds rate forecast showed no rate change in 2019, although the range of contributing forecasts moved sharply down, with almost half of the “dots” in rate cut territory. It appears the FOMC is seeking to maximize flexibility. Gone is the word “patient,” and in its place the FOMC said it would “closely monitor” incoming data and “act as appropriate to sustain the expansion.”1
This statement reinforces the about-face the Fed has made on monetary policy: a 100 bps swing toward easier monetary conditions over the past seven months.2 Fed rate expectations have largely moved in reaction to market gyrations. The market swoon of Q4 2018 washed away rate hike intentions. In May, further trade-related volatility cemented in rate cut expectations, once again giving markets a boost.
Three reasons for caution, not celebration
But going forward, this change in policy stance should give investors cause for concern, not celebration. We see multiple ways the Fed could add to volatility in the second half of the year. First, significant Fed rate cuts are already priced in. The futures market now places 85% odds of two or more rate cuts by the end of 2019. Should the Fed fail to deliver on these rate cuts – for example, if the economy performs better than expected – it will be painful for equities to walk back from their rate cut expectations.
Second, there is a communication problem surrounding this policy shift. Some regional Fed presidents express worry about the impact of trade on the economy, while others voice concern about stubbornly low inflation, a structural problem. And some Fed presidents have expressed a wish for data-driven flexibility, and do not want to commit to a rate cut or hike at this time. Muddled Fed communication is historically a famous cause of market volatility.
At present, the economic data looks solid. Consumer confidence remains close to cycle highs, showing that the volatility afflicting Wall Street has not translated to Main Street. Initial jobless claims, a timely indicator of the labor market, hover near multidecade lows, reflecting the fact that job layoffs are scarce at a macro level. So far, the economy looks set to slow to around 2.0% in 2019, a moderated pace from frothy growth in 2018, but in line with the Fed’s estimate of potential growth.
Third, with interest rates already near historic lows, each Fed rate cut expends valuable ammunition should the economy face a deeper contraction or should a financial market event require intervention. Often, the Fed cuts hundreds of basis points ahead of a recession. What markets see as welcome rate cuts now could look like a premature policy error in the rearview mirror in several years.
The backbone of Fed policy is credibility
Perhaps the biggest risk is to the Fed’s credibility. At what point are Fed rate cuts no longer about supporting the economy, but about supporting the stock market? If the equity markets view the Fed’s continued monetary easing as a sign of weakness instead of strength and stability, it could be a short-term gain but would be corrosive to the Fed’s hard-won credibility, which could cripple monetary policy in the long run.
Indeed, one problem for the Fed is that rate cuts can do little to address the looming threats to the U.S. economy: that broader policy uncertainty around trade, deficits and the upcoming election will derail the current long-running expansion. Each of these issues has already induced market volatility, to varying degrees.
It is likely that the Fed views the June FOMC meeting as a chance to sort out the risks and benefits of policy adjustment. Hopefully, the Fed will use the opportunity to develop a clearer message about the reasons behind its dovish pivot, and follow up with unified communication.
We believe the Fed would do well to take a cautious approach to cutting rates, despite the short-term benefit to financial markets. We expect the fundamentals of the equity markets, including a growth slowdown and broader policy uncertainty, to remain challenged. This is only temporarily pacified by Fed rate cuts, which are already priced in. In the end, whether the Fed delivers one or more rate cuts this year, volatility stands to be a significant challenge for investors at a time when economic uncertainty remains top of mind.