The Fed is poised for an interest rate cut in July, supporting both global equity and bond prices, with geopolitical risks remaining
The Fed maintained its interest rate unchanged at 2.25%-2.5% at its meeting on 19th June, but signaled a strong easing bias, sending the S&P500 to an all-time high, while bond yields reached their lowest level since 2016 (see Markets Section page 3).
Key takeaways from the meeting were:
1) In the post-meeting statement, the description of the outlook was broadly unchanged with a small downgrade to economic activity. Market-based inflation expectations were noted to have declined (5Y/5Y forward rates have slipped to a 5 month low of 1.73% pre-Fed before rebounding to 1.86%), while survey-based inflation expectations were little changed. More importantly, regarding forward guidance, the Fed now views increasing uncertainties around the economic (sustained expansion), labor market (strong conditions) and inflation (near the 2% target) baselines. As a result, the “patient” reference in determining the future stance of policy was dropped from the statement. The Fed will now closely monitor the implications of incoming information and will act as appropriate to sustain the expansion, which will become the longest ever in July (120 months)
2) In the post-meeting press conference, Chair Powell noted that the case for additional accommodation has strengthened, with Fed contacts in business and agricultural reporting heightened concerns regarding trade developments. The Fed abstained from acting on Wednesday because participants would like to see more and learn a lot more on risks in the near term due to: i) US-China trade talks where Presidents Trump and Xi will likely meet at the G20 meeting in 28-29 June; and (ii) a series of important economic data ahead of the July 19 FOMC meeting such as business confidence indicators and the labor market report (July 5).
3) Regarding the Summary of Economic Projections (SEP), the magnitude of the decline in the dots (each FOMC participant individual assessment of the appropriate path of the Federal Funds rate) was surprising. While the median dot continues to show unchanged rates in 2019, 8 out of 17 participants expect at least one 25 bp cut (vs 0 in March 2019 SEP), including 7 who foresee 50 bps of cuts in 2019 (see graph). The median estimate for 2020 was revised down in favor of one cut, followed by one hike in 2021, to a terminal rate broadly in line with the downwardly-revised (by 25 bps) neutral rate of 2.5%. Forecasts for real GDP were little changed at 2% for 2020, while inflation estimates declined slightly (by circa 0.2 pps to 1.8% for 2019 and 1.9% in 2020), suggesting that concerns regarding price stability could weigh on the downward shift in dots.
We use a simple forward-looking Taylor rule based on Clarida (1999, 2017) trying to second-guess one of top-three Fed official’s policy view (alongside Powell and Williams). This specification sets the neutral rate (r*) at zero, while the target rate is a function of the gap between expected inflation and its target level (2%) and the gap between unemployment rate and the NAIRU. Clarida’s forward-looking Taylor rule is consistent with a policy rate 50 bps lower than current levels (see graph below).