(Bloomberg Opinion) -- A trade deal with China is in the works, potentially alleviating one source of stress on the U.S. economy. Still, the Federal Reserve can’t rest easy. The ongoing dispute has shattered investment confidence among business leaders, and one “mini-deal” won’t magically reverse their sense of uncertainty. Lacking an inflation threat to hold them steady, the Fed will likely continue to err on the side of safety with another rate cut at the end of the month.
The minutes of the Fed’s September policy meeting made clear that global growth concerns and uncertainty over trade policy played a part in central bankers’ decision to cut rates. They were particularly concerned that these factors were discouraging firms from “investing in their businesses.” With trade policy high on the list of Fed worries, it is reasonable to expect that policy makers would breathe a sigh of relief at any news of thawing trade relations with China.
The problem for the Fed, and the business community in general, is that it would be premature to believe that the latest agreement with China will prove to be anything other than vaporware. The deal represents only the beginning of a comprehensive pact and it could easily fall apart. We are a long way from rolling back all of the damage done by President Donald Trump’s trade war; firms aren’t likely to splurge on investment spending before it becomes clear that a permanent agreement is on the table.
Without such a comprehensive accord, the Fed can’t yet lose focus on the risks to the economy. This is especially the case given the weak rate of inflation. Consumer prices excluding food and energy rose just 0.1% in September, a pace that will leave the Fed uncertain they will meet their inflation target in a timely fashion.
Potentially more disconcerting for the Fed is the latest sign of faltering inflation expectations. The University of Michigan consumer sentiment report revealed a surprise gain in consumer confidence, suggesting that household spending will continue to be a bulwark against greater economic weakness. The report, however, also showed that long-term inflation expectations dropped to a record low of 2.2.%.
This kind of reading only emphasizes the dangers of letting the economy slip into recession now. With inflation already weak and expectations for consumer prices possibly falling, a recession would intensify disinflationary pressures and make the Fed’s job of stabilizing the economy more difficult. The central bank very much needs to insure against recession; otherwise, they will soon find they are taking policy rates to zero.
The Fed’s decision to resume large-scale permanent open market operations also argues in favor of a rate cut. This may seem counterintuitive, as this seems like an action that would bolster financial accommodation to the economy. The Fed, however, is trying very hard to signal that this isn’t the intention. The buying doesn’t “represent a change in the stance of monetary policy” according to the Fed’s announcement. It is instead intended to prevent a repeat of the repo market challenges of recent weeks that resulted in temporary spikes in overnight lending rates.
If Fed policy makers were to hold off on cutting rates this month, they would risk sending the signal that the bond buying was intended to be a substitute for lower interest rates. That isn’t the message they want to send. Moreover, market participants still think the odds favor a rate cut. Not delivering that cut would thus be a de facto tightening of financial conditions — also not what central bankers want.
To be sure, not everyone at the Fed is in favor of another rate cut. But as it stands now, it’s the least risky path for the central group of voting members of the Federal Open Market Committee. It affords the best protection against a recession that would threaten to undo the benefits received from persistently low unemployment, and potentially send inflation expectations down even lower. Absent the unlikely event of a much stronger run of data in the next few weeks, the Fed is headed toward another rate cut.
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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