Amid the recent market volatility, driven by what we believe are trade and currency wars, there appears to be an important and ongoing struggle for leadership in interest rate policy. Three contenders apparently vie for the controls. Fed Chair Jay Powell and the FOMC have nominal jurisdiction. However, the current political administration may have undue influence and the bond market is also in the running.
We believe that this matters perhaps because when the Fed lost control of fight against inflation in the 1970s, after getting itself pushed around by others, it took a decade plus some extraordinary measures before its credibility was restored. Since then, the Fed’s inflation fighting credentials have remained intact. Now the question we ask is, if rate policy is an instrument of growth and price level control, or if it is instead a “put” on financial markets or even an instrument for leverage in trade policy.
After some fits and starts by the Fed in 2015 and 2016 to remove the zero interest rate policies, it appeared that the markets were accepting of some nine interest rate increases. Last summer, the Fed seemed on a pathway to moving short-term interest rates towards 3%. The Fed forecasts all went to that number. But in October the markets pitched what appeared to be a hissy fit. Equity prices declined, though the Fed carried on with a rate increase in December to the 2.25% - 2.50% range for Fed funds.
By January of this year, the Fed shifted gears, declaring that rates were near neutral and it would be “patient” going forward. We think this was the signal that rate increases should not be the presumption. The markets pressed their views, pricing in various amounts of easing over 2019 and the Fed responded saying that risks related to trade uncertainty had heightened. Perhaps the easing at the July meeting was simply the Fed taking out insurance, but we believe it had little choice. A rate cut was largely expected and we feel that the markets would have clobbered the Fed with a stunning equity drop vote of no confidence had it failed to deliver.
An important question to us is whether this behavior repeats itself. Is the Fed following the markets? There appears to be a further 25 basis point reduction in rates priced into the September meeting, plus perhaps more for October and maybe a 50-50 chance for December. We believe that the markets seem to not be satisfied with just one reduction. Is the Fed’s easing path really going to be this dovish?
We believe that there is another source of pressure entirely: for some time now, the administration has been pointing to overly-tight monetary policy as slowing down the economy. Clearly the ability to press hard in China trade negotiations depends on the continued strength of the US economy. If trade talks are souring the economy, and we feel there’s more than anecdotal evidence of this, then easier monetary policy could limit some of the damage. Whether it wants to be or not, we think the Fed is deeply involved in the calculus of this equation. A weaker economy would give the administration little negotiating leverage.
In the end, the Fed may go a long way in justifying its actions around absent inflation. We think that in its mind, there should be more inflation. The disappearance of inflation baffles the Fed and it desires a bit more of it than we have. Lower policy rates, satisfying the two constituencies above, can be justified as long as inflation remains at bay. We believe that this gives the markets their desirous adrenaline fix and the administration the wherewithal to continue to the trade war one-upmanship with the Chinese.
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