Why the Fed Will Most Likely Cut Rates Next Week

The Federal Reserve’s Open Market Committee (FOMC), the group that sets our nation’s monetary policy, is poised to cut the policy rate at its meeting on July 30–31, but members of the committee are divided. Markets are pricing in a 25 basis point (bp) cut, and we believe that is the most likely outcome, but we also see a meaningful chance of a 50 bp cut.

Following the June 18–19 meeting, a majority of the FOMC was still in favor of keeping rates on hold through the end of 2019 (according to the Fed’s economic projections and “dot plot”). However, the tone of Fed communications has taken a somewhat more dovish shift in the weeks since. Of note, Fed Chair Jerome Powell, in his semiannual testimony before Congress last week (and during a dinner speech at the Bank of France on Tuesday), didn’t discuss the prospect of maintaining the current level of the interest rates (i.e., not cutting) – we see this as evidence that he and others on the Fed’s Board of Governors are in favor of easing and were very likely the participants forecasting at least 50 bps in rate cuts by the end of this year.

Why cut? Potential areas of concern in U.S. economy

With U.S. real GDP growth likely to average a solid 2.5% in the first half of 2019, and the unemployment rate sitting at 3.7% – a multi-decade low – various commentators have stated that the economic data doesn’t justify a rate cut. Furthermore, Powell and other FOMC officials have characterized the U.S. economy as “in a good place.” However, we see several arguments for having a somewhat more accommodative monetary policy.

• Real growth in goods-producing sectors has slowed materially.Despite solid overall GDP growth year-to-date, a closer look at the data reveals severely negative growth momentum in U.S. manufacturing, investment, and exports. And according to surveys, business confidence in the outlook has deteriorated.
• Labor market momentum is slowing.While the recent data shows we have had and thus should continue to have a healthy U.S. consumer to support growth, there is a real risk that the areas of economic weakness spill over into labor markets and consumption more than expected. Payroll growth and (more importantly) aggregate hours worked are slowing as companies cut back hours and slow the pace of hiring in response to weaker sales growth.
• Data is confirming that the real neutral interest rate is lower than some FOMC participants previously thought.Indeed, the U.S. economy appears quite sensitive to rising interest rates. Growth in real investment in structures has slowed as the Fed has raised rates over the last two years. Private construction investment has decelerated, and commercial real estate construction is currently contracting by over 10% year-over-year (source: Commerce Department, Haver Analytics).
• The Fed’s openness to rate cuts has been an important contributor to easier financial conditions, despite higher business uncertainty. Lower interest rates account for much of the easing in financial conditions over the last several months. As a result, if the Fed doesn’t cut rates and bond market yields rise, there is a meaningful risk that ensuing tightening of financial conditions restrains growth.
• Inflationary pressures are modest and financial stability risks manageable. Although the timing of the stronger-than-expected June core CPI print was awkward for the Fed, a broader assessment of the wages and prices data suggests that the inflationary risks of easier monetary policy are modest. Of note, unit labor costs – which adjust wages for productivity gains, and are therefore a better measure of the likely pass-through of higher wage inflation to consumers – have declined for the past two quarters, according to Bureau of Labor Statistics data.

Key takeaways

From all the comments from members of the Fed and for the reasons stated above, a 25 bp cut remains the most likely outcome of the July Fed meeting; however, we wouldn’t rule out a 50 bp cut. Recent U.S. economic data has been somewhat more encouraging, but the broader growth trends in a number of sectors still look notably weak. This, coupled with less room for conventional monetary policy easing and the potential costs of a recession (a retrenchment in labor force participation and a contraction in investments that enhance future productivity), argue for easier monetary policy – including a strong case for a 50 bp cut in July – to help insulate the U.S. expansion from negative economic shocks.

While we do not shift portfolios due to our gut feelings or hunches, we believe it is wise for us and other investors to understand what outcomes are most probable and where the market believes monetary policy is heading.  These monetary policy changes can impact the expected returns of the markets and could therefore change how we believe different portfolios should be allocated.

If you have any questions about your investments or overall financial situation, we would love to connect and see if we can help.