It’s the Fed policy, stupid

The old saying goes that “If you give an inch, they will take a mile.” The Federal Reserve seems to be on the short end of that equation these days. The central bank is being squeezed from two directions and risks losing control of the monetary policy narrative.

The first source of pressure on the Fed is coming from financial markets. That goes back to late last year, when stock prices and bond yields swooned in an apparent rejection of the Fed’s narrative that its four-rate hikes in 2018 were needed to get policy back to an appropriate stance. 

In fact, at that time the Fed’s Federal Open Market Committee (FOMC) was projecting that additional rate increases in 2019 and 2020 would be needed to get to where the Fed should be. The markets sent a signal that the proper interest rate for the economy was considerably lower than the Fed believed, and the Fed has spent all of 2019 backpedaling. 

First, policymakers shifted to a more neutral stance, indicating that they would be “patient” in assessing the outlook. Then, in June, the FOMC suggested that some modest easing might be necessary, and it cut rates at the end of July, though Chairman Powell described the July 31 move as “insurance” and a “midcycle adjustment” rather than the beginning of a string of rate cuts.

It could be argued that a big part of the rationale for the July Fed easing came from financial market pressure. From the time of the June FOMC meeting, financial markets were pricing in a very high probability of a July rate cut (at times, markets were fully pricing in a 25 basis point move and some odds of a 50 basis point decrease).

Fed officials may have hoped that following through with a July 31 rate move would assuage market participants, but “giving an inch” did not have such an effect.

This week, market participants have turned gloomy on trade talks (more on that below), and the Fed finds itself painted into the same corner again looking ahead to the September 17-18 FOMC meeting. 

Currently, markets are pricing in another 25 basis point rate cut for September and some chance of a larger move. In fact, at this time, markets are expecting close to 70 basis points of easing by year-end, i.e. roughly a cut at each remaining FOMC meeting in 2019. 

It is hard to see how the Fed can avoid another rate cut in September unless it aggressively seeks to alter market expectations in the coming weeks, even though economic growth in the first half of the year was both above the economy’s presumed long-term trend and better than expected (relative to forecasts entering the year), the unemployment rate is hovering near 50-year lows, and inflation is only modestly below the Fed’s 2 percent target.

A month or two ago, St. Louis Fed chairman James Bullard was a hero to many nervous financial market participants, as he was one of the first Fed officials to publicly call for a rate cut. This week, he noted that he was still in favor a cumulative 50 basis points of easing this year, the same position he has had for several months, and the markets panned his comments as not forceful enough. He noted that the Fed has already taken trade uncertainty into account, but financial markets have other ideas: “Give them an inch and they will take a mile.”

Of course, the impetus for the latest leg down in interest rates and stock prices followed President Trump’s announcement last Thursday of a ratcheting up of tariffs on China. 

This is the other half of the pincer movement against the Fed. President Trump has been blaming tight Fed policy for slowing down an otherwise robust U.S. economy for some time. His rhetoric has become more frequent and more vehement in recent weeks.

Whether intentionally or not, the administration’s trade strategy is putting heat on the Fed. Many market participants argue that President Trump is turning the screws on China in part to get the Fed to do his bidding—namely, cutting rates to boost the domestic economy heading into his re-election campaign. 

I am not a strong believer of that hypothesis, but I would subscribe to a softer version: the president’s leeway to press the trade negotiations depends in large part on the continued vigor of the U.S. economy (and to an extent, the stock market). If the economy begins to tank in the wake of the souring of trade talks, then President Trump’s re-election prospects would most likely dim. As a result, he can push but must be careful not to push too hard. A certain amount of short-term pain to achieve the long-term gain of a broad trade deal with China would be a worthy trade-off, but probably not in the president’s mind if it costs him re-election. 

Ironically, whether it wants to be or not, the Fed is a central player in this equation. If the Fed responds to a deterioration in the trade talks by easing policy, then, to the extent that boosts the domestic economy, it actually gives the administration a little more wiggle room to pursue a hard line on trade. In contrast, if the Fed were to draw a line in the sand and say that there would be no more easing, it would diminish at the margin the leverage of the trade hawks in Washington.

Thus, the Fed faces a tricky situation. On the one hand, a monetary policy that responds to the risks to the outlook may point to additional “insurance” rate cuts.  However, the more the Fed eases, the more that the administration’s trade policy may exacerbate the very conditions justifying the rate cutting in the first place. Similarly, each rate move by the Fed in the current environment may only embolden market participants to press for more at future FOMC meetings. 

Without a doubt, Chairman Powell is in the hot seat.

Stephen Stanley is chief economist at Amherst Pierpont Securities.