The Fed is under fire for being too hawkish because policymakers aren’t following the market’s interest rate projections. But there are flaws at the heart of this argument that suggest the market might be wrong. Last week’s Fed policy decision to cut interest rates by 0.25% was very much expected, but the accompanying statement denying the start of a rate-cutting cycle – Jerome Powell called it a mid-cycle cut – implies the Fed isn't headed where the market expected.
Ever since the Fed pivoted from hikes to cuts in March, the market has predicted the Fed would begin a series of cuts, despite upbeat domestic growth. Of the various arguments put forward for this expectation, the one that makes the most sense has to do with inflation. The US labour market is currently at historically low unemployment, and there is no sign of inflation. Given that the current interest rate setting of 2.50% is lower than the typical ~5-6% at the end of an economic cycle, the policy prescription is to cut rates aggressively and cut early to maximise their impact.
The recent inversion of the yield curve – when short-term rates exceed long-term rates – which usually presages an economic decline, also signals a lack of market conviction that the current monetary policy can generate inflation. Proponents of pre-emptive cuts argue that aggressive rate-cutting will dramatically lower near-term rates – in anticipation of yet more cuts no doubt – and the stimulative action will allow the economy to pick up the pace. This, in turn, drives expectations of future inflation, which increases far-dated interest rates and rights the previously inverted yield curve.
When viewed at the proverbial 30,000 feet it's a persuasive argument for increased inflation, but it starts to fall apart when the actual mechanics of this process are viewed up close. In this chain of events, the dramatic decline in rates automatically results in economic growth. In the current environment, this is simply too optimistic an expectation. After nearly a decade of easy monetary policy, followed by only modest rate hikes at the Fed, the current level of interest rates isn’t an obstacle to growth. In fact, the impediment to global growth is more probably a contentious and uncertain political environment which is depressing business investment. Lower rates simply won’t fix that Twitter-rant induced problem.
The week ahead
Trade-weighted Sterling ended last week at the low of its range. Unless further political developments heighten the risk of a no-deal Brexit, Sterling may end up trading rather flat given the quiet economic data calendar.
Last week’s Dollar strength was disrupted by Trump’s threat of more Chinese tariffs, wiping out the impact that a more-hawkish-than-expected Fed had on the single currency. The week ahead is light on US data, but the Dollar may be volatile as US-China trade tensions develop.
Investors are pricing in a September interest rate cut as a near certainty, and while the week ahead is light for data, signs of further Eurozone weakness risks pushing the Euro Index back towards two-year lows.