The Federal Reserve will lower interest rates on Wednesday for the third time since July, erring on the side of caution in an effort to spur economic activity and offset risks to the outlook. Still, the data doesn’t justify an endless series of rate cuts, and the Fed will need to start signalling more explicitly to the financial markets what economic conditions will bring what the central bank calls a “mid-cycle correction” to monetary policy to an end.
Estimates of economic growth for the third quarter hover on the low side of 2 per cent. While this places growth close to the Fed’s estimates of the long-term sustainable pace of activity, it does not want to see growth slow further and threaten to put upward pressure on unemployment. Policy makers have gained a new appreciation of the benefits from sustained, low unemployment and fear losing those benefits. Moreover, persistently low inflation — and signs of falling inflation expectations — only enhances the case for easing monetary policy.
Still, the incoming data is not terrible. The housing market has regained momentum in recent months, consumer sentiment remains high, core manufacturing orders continue to hold roughly steady and initial jobless claims remain at very low levels. The relative stability of the overall economy and lack of recessionary-type data helped drive a split among the rate-setting Federal Open Market Committee between those who want more easing and those ready to stand pat.
For now, the more dovish members of the Fed will prevail. Key policy makers made no effort to turn market expectations away from near-certitude that this week will bring lower rates. Vice chairman Richard Clarida passed on an opportunity to shift expectations in a speech just before the Fed’s blackout period. And while Mr Clarida repeated the mantra that the economy is “in a good place,” there were more dovish than hawkish notes in the speech. He noted that global growth forecasts “continue to be marked down” and that policy was only “somewhat more accommodative” after two rate cuts. The combination suggests that he is leaning toward more easing to limit downside risks.
Note that the issue of dovish market expectations is no trivial matter. Although hawkish voices will dissent on a rate cut decision, more moderate policy makers will likely view market expectations as reason to side with the doves.
It is not that the Fed would worry much about creating a one-day disruption in markets. Rather, a hawkish surprise by the Fed would lead market participants to reassess their understanding of the monetary policy process and anticipate a more hawkish policy path going forward. That would be a de facto tightening of policy, which runs counter to the stated policy preference of easier policy. Moreover, it would reverse the positive impact of the Fed’s dovish policy shift that chairman Jerome Powell says has supported the economy this year.
All that said, the Fed will not continue cutting rates indefinitely. Absent a deterioration in the data flow, central bank officials will eventually become confident that they have turned policy sufficiently accommodative to overcome existing risks to the forecast. At that point, they will want to pause while they assess their handiwork.
The point at which they want to pause could come after this week’s cut. Policy rates will be sitting in the range of the lowest forecasts in the Fed’s September Summary of Economic Projections. That seems like a reasonable point for the Fed to signal, for example, that future rate cuts will depend explicitly on a renewed worsening of the data flow. This would be a gentler push on market expectations than would be achieved via abruptly surprising with a pause this week.
Policy makers have no good reason to flout dovish markets expectations for a rate cut this week and risk returning to the turbulence that engulfed markets late last year. Moreover, they certainly won’t want to risk the pushing the economy out of its “good place". Even so, watch for signals that the Fed doesn’t want markets taking another rate cut for granted. It won’t give up the possibility of a cut, but it will soon want to place some more conditionality around that possibility.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch