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Powell Tested by Bet That Economy Only Needs Modest Easing

That’s the message from trade-war-weary investors, who forced 30-year U.S. Treasury bond yields toward a record low.

Powell Tested by Bet That Economy Only Needs Modest Easing
Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, D.C. (Photographer: Andrew Harrer/Bloomberg)

(Bloomberg) --

A moderate reduction in Federal Reserve interest rates may not be enough to offset a slowing global economy that could unleash powerful forces that push the U.S. closer to recession.

That’s the message from trade-war-weary investors, who forced 30-year U.S. Treasury bond yields toward a record low at one point on Wednesday.

They later bounced higher, but pricing in interest-rate futures markets continue to show a rising probability of 75 additional basis points of easing this year following the Fed’s quarter-point move last week.

Powell Tested by Bet That Economy Only Needs Modest Easing

The Fed’s unspoken debate with financial markets is essentially over the hard-to-quantify risk of whether an escalating trade war will re-draw a tightly-coupled global trading system, further weakening investment, slowing employment and unleashing financial disruption.

Or will it be more like a slow evolution, which the Fed could manage through with the “mid-cycle adjustment to policy” as Chairman Jerome Powell described the rate outlook following the July 31 cut.

“We don’t really know exactly what the downside risks are at the moment, and it’s tricky,” Chicago Fed President Charles Evans told reporters Wednesday during a media briefing in Chicago at which he made clear he was open to cutting rates at the Fed’s next meeting in September.

The evidence from recent U.S. economic data is far from conclusive.

Just last month, U.S. companies added 164,000 jobs and measures of consumer confidence appear to be holding up.

The worry is that President Donald Trump’s trade war with China -- which he escalated the day after the Fed meeting -- leads to investment paralysis that is now chilling the U.S. service sector, while manufacturing at the heart of Europe slumps.

“The global economy is caught in a giant game of chicken,’’ said Karl Haeling, head of strategic debt distribution at Landesbank Baden-Wuerttemberg in New York. “There are some real consequences.’’

Powell’s reference to a mid-cycle adjustment recalls the Fed’s 75 basis points of easing in the 1995-1996 period, which helped prolong a U.S. economic expansion that went on to become the longest on record until it was overtaken by the one currently underway.

The chairman was trying to steer away from the idea that policy is in a protracted easing cycle headed toward zero. That view was reaffirmed by James Bullard, the president of the St. Louis Fed, who initially called in early June for a rate cut almost two months before Fed policy makers agreed on one.

Bullard said Tuesday that heightened trade uncertainty was already encompassed by his view that at least one more cut was in order for this year, which he characterized as also necessary to return inflation back to the 2% target.

In addition, Bullard said he appreciated the argument for not moving aggressively, given that forecasters still expect the economy to grow and continue adding jobs.

“There is a case to be made, I think, for doing less, and that is where the push and pull is on the committee,” Bullard told reporters Tuesday.

The comments weren’t comforting for investors, who have been buffeted by bad news.

Powell Tested by Bet That Economy Only Needs Modest Easing

A gauge of U.S. service industries -- seen as less vulnerable to contagion from the trade war -- declined in July to an almost three-year low as orders continued to cool. German industrial production in June registered its biggest annual decline in almost a decade.

Despite Powell and Bullard’s outlook, the cost to hedge against the risk that short-term interest rates go negative by the end of 2021 jumped Wednesday to the highest level in 20 months of data, according to the prices of call options on eurodollar futures contracts.

“My view is that they have to do more, that the mid-cycle adjustment will not be enough to offset the downside risks,’’ says Priya Misra, global head of rates strategy at TD Securities, which is forecasting two more quarter-point cuts this year.

“They really don’t see signs of a broad-based slowdown,’’ she said. “I don’t see a lot of signs that the weakness in manufacturing stays in manufacturing.’’

With the U.S. summer vacation season well underway, there are no more Fed officials currently scheduled to speak publicly for the rest of the month, though the central bank’s annual policy symposium in Jackson Hole, Wyoming from Aug. 22-24 traditionally draws a number of policy makers who make comments.

Evans, for his part, sounded open to the argument that the Fed will need to do more.

“You could take the view that the risks now have gone up, and as we think we’re going to get closer to the zero lower bound with higher probability, that would also call for more accommodation,” Evans said. Nevertheless, he continues to see GDP growth of 2.25% this year and “the labor market still looks good.’’

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net;Matthew Boesler in Chicago at mboesler1@bloomberg.net

To contact the editors responsible for this story: Alister Bull at abull7@bloomberg.net, Scott Lanman

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