Fed on hold for now but may be forced to cut again

On the back of the Fed's new ‘wait-and-see' approach and the better-than-expected October jobs report, we update our Fed call and now expect only one more cut in 3-6M (previously three more cuts). The timing of the cut is difficult but, as the Fed wants to see how things play out, the March meeting is probably the earliest possibility. Most FOMC members (including the doves) have said they think the current policy stance is appropriate and that it would take a further deterioration of data to make further cuts.

We keep a cut in our forecast profile, as we still believe the US economy is more fragile than the Fed believes and that the renewed trade optimism is unlikely to be enough to trigger a rebound in business investments just yet. Most soft indicators on investment intentions signal a further decline in business investments. In our view, we need a more permanent deal for investments to kick off again (we assign a 50% probability of this happening). The world economy also looks fragile, in particular in Europe, despite the early signs of stabilisation in China.

A few things have surprised us. First, hard data have not been as weak as indicated by the soft indicators. Second, we thought the Fed would deviate from its historical pattern by easing more in this ‘mid-cycle adjustment', as inflation and inflation expectations remain low compared with the 2% target, limiting the costs of easing monetary policy. Marketbased expectations have rebounded but remain around the level where the Fed made its Uturn at the beginning of the year. Survey-based indicators are at historical lows. Third, the trade war negotiations have come back on track faster than expected.

In this piece, we also take a closer look at how economic indicators usually develop when the Fed makes ‘insurance cuts' and ‘recession cuts'. Based on the charts, it is clear the Fed usually begins to cut aggressively when we see a more severe slowdown in private consumption growth and/or jobs growth (i.e. when it is too late). Now the Fed has revealed it is not going to deviate from this, we probably need a combination of slower private consumption and jobs growth for the Fed to start cutting more. Right now, private consumption and employment are growing at decent paces. The Fed is also relieved that the US 10s2s and 10s3m spreads are now positive again (i.e. investors think the probability of a recession has declined). If core capex moves sharply lower, as hinted by, for example, the CEO confidence indicator, it may change the Fed's thinking as it did in 2001, which was an investment-driven recession.

We want to stress that the outlook for the Fed funds rate has become more uncertain and, admittedly, we do not have a strong narrative currently. If hard data begin to move lower as suggested by soft indicators, or we get a setback in the US-China trade negotiations, the Fed may soon cut rates again (if the opposite is true, the Fed is likely to remain on hold; a hike still seems unlikely in this scenario, as Fed Chair Jerome Powell said a hike is not on the cards until inflation starts moving persistently above 2%). In addition, monetary policy is not as expansive as one may think, as the cuts have taken the Fed funds rate only down to neutral. Without more easing, it also increases the probability the Fed will need to cut all the way down to 0%, as a response to a recession.

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