The Federal Reserve is likely to cut interest rates by less than financial markets expect over the rest of 2019 given robust jobs growth in the US, Fitch Ratings says. A 25bp cut now appears probable at either the July or September FOMC meeting but is unlikely to signal the start of a series of interest rate cuts, in contrast to the path currently priced into Fed funds futures markets.
Dovish congressional testimony from Fed Chairman Powell last week suggests that an interest rate cut looks likely later in 2019. Powell’s comments included a surprisingly prominent emphasis on low inflation considering that several core inflation indicators remain around 2%. He also stated that downside risks to US growth from weakening global expansion and trade policy uncertainties had remained in place since the Fed’s meeting in mid-June.
US GDP continued to grow faster than potential through 1H19, consumer spending indicators are solid and job growth is robust in the context of a historically tight labour market. So, the forthcoming cut seems likely to be presented as an ‘insurance policy’ move aimed at reducing downside risks rather than a ‘data-driven’ policy response. Business investment is slowing in the face of rising trade policy uncertainty and manufacturing output has fallen, but US GDP still looks likely to grow by 2.4% in 2019 before slowing to 1.8% next year, as forecast in Fitch’s June “Global Economic Outlook”. The Fed’s own projections show a similar, above trend, rate of expansion over 2019 and 2020 combined.
In this context, the Fed seems most likely to cut rates once by 25bp in 2019 and then leave rates on hold through 2020 rather than embarking on a series of rate cuts. The three rate cuts currently priced into futures markets by end-2019 would entail the Fed undoing nearly all of the tightening enacted in 2018, which seems quite unlikely unless the US economy slows down much more sharply than we (and the Fed) currently anticipate.
A further sharp escalation in the US-China trade war could prompt a more abrupt US economic slowdown. But it is unclear in these circumstances how much lower interest rates would really help in offsetting the deleterious impact of trade policy disruptions on US exports, business investment and real wages.
Fed easing that is less aggressive than financial markets anticipate could spark some market volatility against the backdrop of the recent reinvigoration of investors’ search for yield. If market participants take the view that central banks will continually lower rates to support both economic activity and asset prices (akin to ‘the Fed put’), this runs the risk that financial asset prices become particularly vulnerable to surprises in central bank policy reactions.