What The Fed Will Do This Week, And Why

This week’s Federal Reserve policy meeting is likely to signal another dovish shift in U.S. monetary policy, though not as pronounced as markets have already priced in and Wall Street strategists are increasingly predicting. In the process, the central bank will highlight the tricky policy trade-offs and inherent uncertainties facing the Fed and other key central banks.

With the Fed already likely to signal on Wednesday a clearer path to lower interest rates compared to what has been previously communicated, the questions are how much, when and why.

Context

While the U.S. economy has shown some signs of greater fragility, not all of its growth dynamics have weakened. For instance: The data on economic activity and sentiment remain mixed, with some strong readings persisting; and while the latest jobs report fell short of consensus expectations, the three-month averages for job creation and real wage growth remain solid for these inherently noisy data series.

Inflation, on the other hand, continues to undershoot the current specification of the Fed’s target of 2 percent; and is falling even further behind the symmetrical 2 percent target over time that the central bank could well shift to at the end of its ongoing framework review of monetary policy.

Concerns about more fragile growth and undershooting inflation are amplified by what’s happening globally.

International trade continues to weaken in the face of trade war uncertainties. These uncertainties are amplifying the effects of Europe’s political inability to move forward on much-need pro-growth policies. They are also complicating what is an inherently tricky economic and financial transition for China. And all this threatens the robustness of the wedge that central banks have collectively maintained between elevated asset prices and more sluggish economic fundamentals – a wedge that has repeatedly countered risks of disruptive market volatility, but has done so by encouraging high risk taking in certain segments and threatening medium-term financial stability.

Put all this together and the case can be easily made for an “insurance cut” package – that is, a 25-basis-point cut in interest rate wrapped in forward guidance that signals a path for further rate reductions over time and a lower terminal point, as well as stress policy flexibility and responsiveness. But – and that is one of the Fed’s dilemmas – markets have already priced a very aggressive policy response, including up to three to four rate cuts this year alone. Moreover, it is far from clear that continued reliance on dovish central bank policies will do much to ease what structurally ails growth and inflation determination. Meanwhile, the risk of unintended consequences, including eventual economic and financial collateral damage and greater vulnerability to political interference, continues to climb.

Fed Announcement

The most likely takeaway from this week’s Federal Open Markets Committee meeting will be central bank willingness to cut rates as a supplement to the dramatic policy U-turn earlier this year.  The first cut will probably not take place this week but rather at the next FOMC meeting scheduled for July 30-31. It is likely to amount to a 25-basis-point reduction as part an open-ended cycle of rate cutting, with a smaller probability of a 50-basis-point “one and done” approach.

Accompanying the downward forecast for rates (the “blue dot”), the narrative coming out of the meeting will stress the Fed’s willingness and ability to respond in a timely manner as required by economic developments. This narrative will be reinforced by hints of what is likely to come out of the monetary policy framework review that Chairman Jerome Powell initiated a few months ago.

The common driver of these predictions is the unusually fluid state of the domestic economy, and to a larger extent the global. With that reality, the Fed will wish to retain as many policy options as possible, even if there is some risk of disappointing markets that are pressing for upfront signals of very dovish Fed measures.

This tradeoff – between what the economy would warrant at this stage and what markets want to further elevate asset prices and repress financial volatility – points to the risk of another Fed mis-communication. It is not an easy balance to strike. And it is made harder by the absence of well-communicated strategic underpinnings to the current monetary policy stance (which also makes the Fed more vulnerable to political pressure and to market criticisms of being a flip flopper).

Finally, none of this would allow the Fed to overcome an important inconsistency: between sky-high expectations on what it can and should deliver, and its tools that, at best, can only buy time for the economy and markets. It is a trade-off that deepens a long-standing dilemma that the central bank faces: between wishing to hand off macro-economic policy leadership to policymakers with better-suited tools, and fearing a bungled handoff.

The Fed is not the only central bank facing this dilemma. Other systemically important central banks are in this position as well, as demonstrated recently by comments from the Bank of Japan, the European Central Bank and the People’s Bank of China. Central bankers feel they have no choice but to continue to position themselves for now as the “only game in town” policy-wise. And, notwithstanding mounting concerns about overreach and mission creep, they will continue to do so while also underwriting all of the associated (and mounting) risks to both their own credibility and economic and financial well-being that come with that.

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

To contact the author of this story: Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor responsible for this story: Philip Gray at philipgray@bloomberg.net