- The Federal Reserve is set to cut interest rates in its critical September decision.
- The market reaction depends on what the Fed signals in its dot plot.
- Chair Jerome Powell's comments about employment, inflation, and trade may also move markets.
"The Federal Reserve should get our interest rates down to ZERO, or less" – that tweet from President Donald Trump is unlikely to become a reality anytime soon – but the Fed is on course to cut rates.
The market reaction depends on the rate reduction but also hints toward further moves. Before we delve into the five scenarios for the Fed decision, let us examine why the central bank is on course for more stimulus, detailing the good, the bad, and the ugly.
The good – Domestic growth and consumption
The bank described its rate cut in July as an "insurance cut" – only a one-off or a "mid-cycle adjustment" rather than the beginning of a cycle of monetary loosening. It had reasons to sound positive, which remain relevant.
The US economy continues growing at a satisfactory pace – 2% annualized in the second quarter and indicators for the third quarter are also pointing to a similar rate.
The US consumer – responsible for around 70% of the economy – remains on a shopping spree. Personal consumption contributed 4.3% to the economy's expansion, and recent figures seem upbeat as well. And while the University of Michigan's gauge of consumer sentiment dropped, the Conference Board's measure remains at record highs.
Americans have more money to spend as their salaries are on the rise. Average Hourly Earnings rose by 0.4% MoM and 3.2% YoY in August – better than expected and encouraging figures.
The bad – Investment and global growth
Investment in the US economy has remained weak. Recent Durable Goods Orders figures have exposed this worrying trend. Core orders dropped by 0.7% in July – the worst since October 2016. The revision to GDP growth for the second quarter was also disappointing. Both household investment and business investment are contracting. They have dragged annualized expansion down by 1.1% back then.
Another worry for the Fed – in July and also now – has been growing outside the US. The German economy is on the verge of a recession after contracting in the second quarter – and is dragging the euro-zone down. Industrial output in China rose by only 4.8% YoY in July – the slowest pace in 17 years.
The ugly – Trade and the Fed's mandates
One of the Fed's main reasons to cut rates for the first time in over a decade has been the trade war. In late July, the US and China were in a "trade truce" that had – been declared after a summit between Presidents Donald Trump and Xi Jinping a month earlier.
Trump announced new tariffs on the day following that decision only to retreat on some of those levies two weeks later. Later in August, China made public its counter-measures and the US hit back with new duties coming in October. After the planned, American and Chinese steps came into effect on September 1, the world's largest economies sought to defuse tensions and scheduled new talks. Washington announced a delay in October's tariffs while Beijing promised to buy new goods. An "interim" deal with a smaller scope is now on the cards.
All in all, the trade front remains murky at best – complicating the Fed's task – but perhaps implying less future investment.
The Federal Reserve's two mandates also paint a mixed picture. Subdued inflation has been another driver of the previous rate cut – but it is on the rise once again. Core Consumer Price Index has accelerated to 2.4% in August, up from 2.3% in July and 2.2% in June.
The Fed's second mandate is full employment. While the labor market remains robust – as seen by low unemployment at 3.7% and rising wages – recent wage growth has been slow. The economy gained only 130,000 jobs in August and 149,000 in July, according to the latest figures.
The components of a cut
All in all, the Federal Reserve will likely respond to the mixed data and rising uncertainty by cutting interest rates – being "better safe than sorry." Bond markets have been implying a reduction and Jerome Powell, Chair of the Federal Reserve has not pushed against it in his last pre-decision speech.
The Fed usually moves rates by 25 basis points – and that is the most likely case now. However, Eric Rosengren, President of the Boston branch of the Federal Reserve, has suggested the current policy is appropriate – and voted against the rate cut in July. On the other hand, James Bullard, his colleague in Saint Louis, indicated that a 50bp rate cut would be preferred under current conditions.
The decision is accompanied by a statement which details the current economic conditions, explains the decision, and states the voting pattern. Concerns regarding the labor market would serve as an adverse development while a more upbeat assessment of inflation and inflation expectations would serve as an upgrade.
While it is of importance, the focus will likely shift to the Fed's forecasts for growth, inflation, employment, and most-importantly – interest rates. This dot-plot will probably see downgrades as to where interest rates will be by year-end and for the next few years. Investors will probably respond to the forecast for 2019 – which will indicate the Fed's moves in the remaining two meetings.
Last but least, Powell will meet the press to explain the decision, provide an outlook, and answer questions. Traders will try to understand the next steps. Apart from direct comments on rates – which Powell may refrain from – his insights on rising inflation, slowing job growth, and trade is of highest interest.
Unless the statement and Powell and provide earth-shattering revelations, the dollar and broader markets will likely move more on the rate cut and the dot plot – and these determine the scenarios.
1) Rate cut now, none later
In this scenario, the bank meets market expectations for September but sticks to its guns that recent moves are only "adjustments" and it prefers to leave rates unchanged unless the data warrants further move. The Fed would be responding to the latest trade detente and rising inflation. Moreover, it would defend its independence against Trump's constant criticism.
The US dollar would likely rise as the cut is priced in, and markets would be disappointed by the lack of a commitment to do more. The scenario has a medium probability.
2) One now, one later
If the dot-plot implies one more 25bp cut by year-end, the Fed will acknowledge that its outlook has deteriorated since July – it is not only cutting rates earlier than expected but signaling another one down the road. A third rate reduction in 2019 would wait for the next Fed forecasts. While it would convey a message of concern, one more cut would be a measured response.
This scenario is close to market expectations, has a high probability, and would likely leave the dollar unchanged at the end of the day. In this case, Powell's words would have more impact than in other scenarios, as they would help decipher the Fed's thinking.
3) One now, two later
Hinting at rate cuts in the remaining two decisions of the year would already be a sign of significant worry – showing the Fed is pessimistic about trade, investment, and also employment.
Such a scenario would send the dollar lower and has a medium probability – it is more dovish than markets expect. However, the slide in the greenback may be moderate as the Fed would still say the next moves depend on the data.
4) A double- dose rate cut
If Powell heeds to Bullard's advise and cuts rates by 50 basis points, it will express outright panic. A non-standard rate cut is usually reserved for abnormal times. While markets would initially cheer at more easy money, it would also reflect that the Fed is either anxious about investment and trade – or is less independent. Both developments may cause investors to lose confidence.
The scenario has a low probability and would send the dollar plunging, but Powell may opt for it – trying to do "whatever it takes" – to borrow a phrase from European Central Bank President Mario Draghi.
5) No rate cut
This scenario is highly unlikely but cannot be ruled out, and may send the dollar surging. The Fed Chair and his colleagues may opt to adhere to the hawks' view that the economy is doing well – and also defy Trump's angry tweets.
The Fed could base the decision on rising inflation and stress it is data-dependent. Moreover, it could cite the hopes for an interim deal as a reason to wait and see.
The Fed decision, due out on September 18 at 18:00 GMT and especially the dot-plot are critical and will set the tone for markets for a significant period. The bank is set to cut its rates, but the details of the cut and clues for future moves are crucial for the market reaction.
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