The Federal Reserve kicked off a rate-cutting cycle last week with a 50 basis point move, largely overshadowing the Bank of England and the Bank of Japan, which remained on hold, and pushed the S&P 500 to a new high.
As is customary, Fed Chairman Jerome Powell took questions from reporters at a post-meeting press conference. However, the Federal Open Market Committee's (FOMC) change in its previous guidance raised a series of more difficult questions.
Here are a few of the most important questions.
What does data dependency mean?
Powell explained the rate decision with confidence and ease, seeming to say, “Nothing to see.” It worked: Investors reacted positively, dispelling their earlier fears that a big rate cut would be seen as a sign of panic among policymakers.
But his statement was a bit disingenuous. By cutting rates by 50 basis points, the FOMC withdrew its earlier suggestion that it would ease from the regular 0.25 basis point. More importantly, the new Summary of Economic Projections (SEP) quietly introduced a major reassessment of what the Fed needed to do to achieve a soft landing for the US economy.
The new GDP growth forecast is essentially the same as in June. The inflation forecast is lower and the unemployment forecast is higher, which does not indicate that economic conditions are materially different from those predicted three months ago.
But the interest rate path that Fed policymakers believe is necessary to reach their goals is now much lower.
Powell would probably say this is just an exercise in data dependence: when the data changes, policymakers change their views. “We took all of this data into account and concluded this is the best thing for the economy,” he said. If anyone questioned his changes to the dot plot, he would probably give a similar answer.
But there are some problems with this argument.
The change in the dot plot from June to September is huge. It took months of poor inflation data earlier this year for rate setters to slash their expectations for rate cuts from three to one by 2024. In contrast, the labor market data of the past few months, while slightly disappointing, has not raised alarms.
That doesn’t sound like a strong backdrop to justify the significant dovish shift taking place beneath the surface of the SEP.
Has the Fed lost the market's trust?
The rate cut was expected by the market. Investors began pricing in a 50 basis point rate cut as early as July, despite policymakers insisting that the Fed would likely ease gradually. In the end, traders’ guesswork won out.
Markets now expect the Fed to reach its projected terminal rate of 2.9% in September 2025, more than a year earlier than most rate setters predict. In other words, they expect the Fed to implement about eight rate cuts over the next 12 months or so. The Fed itself predicts only six.
What does this mean for the Fed?
It could be that the market no longer trusts the rate setters. This is plausible given the poor performance of the dot plot in accurately predicting the Fed's subsequent rate path. This raises another question, that if its decisions are indeed data-dependent, then should the dot plot be abandoned? Not only does it not communicate policy clearly, it could also damage the credibility of policymakers.
But overly dovish markets could help in some ways. Powell made clear last Thursday that the Fed has not yet declared victory over inflation. If markets continue to keep financial conditions loose beyond what the Fed itself has indicated, the central bank can have it both ways: maintain a “roughly balanced” stance between its dual mandates and enjoy the stimulative effects of lower borrowing costs.
The risk is that a market correction will eventually come. On a more optimistic note, anyone who isn't tired of the 25 or 50 basis point debate has a lot to look forward to.
How politically risky is the decision?
Presidential candidate Trump pays unusual attention to the Fed's decisions. His comments on rate cuts are not surprising.
"It shows that the economy is in terrible shape, assuming they're not just playing politics," he said, a view shared by some Republican lawmakers. Trump's running mate, JD Vance, was unusually cautious.
For his part, Biden called it a "progressive statement" and sought to attribute the drop in inflation to his administration's policies. Harris simply called it "good news."
Powell has a good record of resisting political pressure to move interest rates. While he is best remembered for his 2019 spat with Trump, there have also been some Democrats who have sought to influence the Fed's rate decisions.
But Trump has made direct threats to the Fed’s independence before, and the decision to kick off an easing cycle on the eve of an extremely tense election is unlikely to endear the central bank to the erratic former president.
This is another issue to worry about if Trump wins the November election.
The article is forwarded from: Jinshi Data