The Fed's Coy Stance on Rates Risks Further Damage

(Bloomberg Opinion) -- The Federal Reserve can try to be coy about the chance of an interest-rate cut at the September meeting, but that train has already left the station. Stuck in a negative feedback loop with President Donald Trump and financial market participants, while simultaneously under pressure amid falling global interest rates, policy makers will find themselves left with few options but to further ease short-term rates.

The Fed tied last week’s rate cuts tightly to trade tensions, perhaps too tightly. President Trump followed with an escalation of the trade war with China. Equities sank and market participants promptly took interest rates lower as expectations for further rate cuts grew. Trump threw more gasoline onto the fire on Wednesday by describing the Fed as incompetent and calling for further rate cuts. This entire situation creates a vicious cycle.

St. Louis Federal Reserve President James Bullard had tried to break this cycle Tuesday by untying future policy actions from trade tensions, saying policy “cannot reasonably react to the day-to-day give-and-take of trade negotiations.” But threats of delayed Fed action will only worsen market conditions, as evidenced by the immediate response to Bullard’s comments: A flattening of the yield curve, which signaled traders are worried the central bank will do too little, too late.

On Wednesday, his colleague Chicago Federal Reserve President Charles Evans also signaled the need to see how developments unfold, while acknowledging that a case could be made for more immediate action:

“There is a role for risk management, and you could take the view, as I have, that inflation alone would call for more accommodation than we’ve put in place with just our last meeting … You might take the view that things have perhaps created more headwinds against that, and it would be reasonable to do more than just that. I don’t know. I have to look at it as the data come in.”

Even if Fed policy makers could break the direct link between trade tensions and monetary policy, they will still face plenty of pressure to cut interest rates. First, there will still be an indirect link between trade and policy as it plays out in financial markets. The Fed cannot ignore financial market distress forever and just hope that Wall Street’s problems don’t filter through to Main Street.

Second, global interest rates are plummeting; the entire yield curve for German government bonds is now negative. This places downward pressure on U.S. yields and implies a lower neutral rate of interest. The Fed will have to acknowledge that reality by lowering policy rates or face an unwelcome tightening of financial conditions. And finally, it’s fairly clear from recent employment reports that the U.S. economy has decelerated, providing further reason to cut rates to protect against a further slowdown.

Putting it all together, the Fed isn’t going to get away with a “one and done” after last week’s rate cut. The only real questions are how much Fed speakers will follow Bullard’s lead and seemingly resist a rate cut and the depth of rate cuts ahead. Greater resistance now likely only means deeper rate cuts in the future. On this point, New York Federal Reserve President John Williams’s ill-timed speech regarding the need to act quickly in the face of threats to the economy is relevant here even if the Fed doesn’t see the relevance yet. Bond markets already signal that sustaining the expansion requires a strong Fed response.

Looking forward, I think it will be hard for the Fed to do anything but cut rates at the September policy meeting. A quarter-point rate cut is already priced in with 100% probability and odds of a 50 basis point cut have grown. I don’t see that conditions will improve sufficiently in the next few weeks to flip those odds. That said, I don’t think the Fed is ready to own that rate cut yet, and certainly not any beyond that. Hence, I see a high probability we will see further comments like those by Evans – openness but noncommittal to further rate cuts. We will probably need to wait until the annual Fed symposium in Jackson Hole, Wyoming, later this month for a more consistent policy direction to emerge.

To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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