Since the 1970s the Federal Reserve has aimed to fulfill its “dual mandate”: keep inflation moderated and maximize employment. And as it stands today, both of those objectives are on track — yet, the central bank’s work isn’t done.
Although inflation is low, employment is high, and the economy is fundamentally in good shape, clouds are coalescing in the form of trade fears and weakening global growth. Those dual fears have pushed Fed Chairman Jerome Powell to broaden the central bank’s mandate to include acting, when appropriate, to sustain the current economic expansion, which is the longest on record. And on Wednesday the Federal Reserve cut rates by 0.25 percent for the second time this year.
Brent Schutte, chief investment strategist at Northwestern Mutual, views the latest cut as another sign that current Fed policy is increasingly dependent on trade war meanderings rather than economic data. While Schutte believes the Fed should be aggressive and was hoping for a deeper cut in July, he thinks the 0.25 percent cut strikes the right balance given the latest twist on trade.
“Trade rhetoric has ratcheted down quite a bit lately, with goodwill gestures coming from both sides. You’re also seeing the yield curve push back in the right direction,” says Schutte. “The market had priced in a 0.25 percent cut, and the Fed didn’t want to risk disappointing to the downside.”
WHAT’S DRIVING THE FED’S DECISION?
Every day, there’s a tug-of-war between positive and negative economic signals coming via the markets, businesses, consumers, central banks and a host of other sources. The Fed’s job is to sit on the sidelines and closely monitor both sides of the rope. But when that center mark begins to lurch toward the negative side, the Fed steps in and uses its policy tools to tug the rope back to the positive side.
The trouble for Fed officials currently is that this economic tug-of-war match is at a stalemate, making it difficult to determine when, or if, the Fed should pull the economy in the right direction or save its energy for later.
“The Fed has to determine what the risk of not acting is, and right now the cost-benefit analysis favors doing something rather than nothing,” says Schutte.
On one end of the rope are clear challenges to growth. The U.S. manufacturing sector contracted for the first time since 2016 in August; consumer confidence — though still historically high — dipped slightly in June; jobs growth came in lower than expected in August (hiring for the 2020 census helped pad those numbers). Collectively, Schutte says these could be signs that the trade war is dampening sentiment and causing companies to slow investments in equipment and labor while they await more clarity on trade.
But there are plenty of positives on the other side of the rope. The U.S. economy, despite challenges, is still growing. Prices remain stable. Consumers, which drive 70 percent of economic growth in the U.S., are still strong as evidenced by solid growth in non-manufacturing sectors. Wages are growing, unemployment is low, and consumer balance sheets aren’t stretched. What’s more, President Donald Trump and Chinese President Xi Jinping lowered the temperature on trade after a hot summer of tit-for-tat negotiations and tariffs.
“I think we’re in a bifurcated economy right now. The services side of the economy still looks good, but you’re seeing weakness in manufacturing. That points the finger squarely at the trade war and the uncertainty that is emanating from it,” says Schutte.
Powell, in July, characterized the economy as well balanced and pointed out that there isn’t a single sector in the economy that’s booming and therefore on the verge of busting. The economy is so well-balanced that Federal reserve officials have been divided this year over rate cuts. In July, two officials dissented from the rate cut decision, essentially arguing a cut wasn’t needed. During the same meeting, other Fed officials campaigned for a deeper 0.5 percent cut. So, what pushed the Fed to cut again in September?
THE FED IS LISTENING TO THE MARKET
Schutte believes the Fed is doing a better job of “listening” to markets, which could explain why the Fed decided to cut rates again even with a mixed, but not recessionary, economic backdrop. Markets tend to perform best when investors’ expectations about the future largely come to fruition. Surprises tend to produce volatility, especially when reality falls short of expectations. In the weeks leading up to the Fed meeting, investors took less-than-stellar jobs, manufacturing and global data in stride because these signs of decelerating growth made a Fed rate cut in September appear more likely.
“The research suggests that when you are at these levels it’s a good idea to go hard and go often with cuts,” says Schutte.
Back in July, Schutte was hoping the Fed would be aggressive and cut 0.5 percent to ease financial conditions and calm uncertainty about trade. But his calculus shifted after the Trump administration “spent” the Fed’s accommodating policy the very next day by announcing new tariffs on Chinese imports. Essentially, the Fed’s efforts to alleviate uncertainty were immediately offset by uncertainty surrounding the new tariffs.
“Theoretically, that means no net new stimulus made it into the economy,” says Schutte. “With the U.S. and China going back to the negotiating table in October, the Fed may have held back on a larger cut this month to gauge the outcome of these upcoming trade talks. The Fed doesn’t really have a playbook for trade wars.”
Schutte believes there are several other factors in play right now. For one, the Fed doesn’t want to appear political, especially in the wake of former Fed monetary Vice Chair William Dudley’s essay arguing the Fed shouldn’t enable President Trump’s trade war by “mitigating the damage” by cutting rates. If the Fed didn’t cut Wednesday, there’s a chance Dudley’s essay would be used as evidence to prove politics is coloring Fed policy.
Another factor was market expectations. As the September meeting drew closer, solid reads on business and consumer confidence, retail sales, diminishing recession fears and firming inflation trends had investors lowering the odds the Fed would cut at all this month (again, that “well-balanced” economy). Still, most traders had priced in a 0.25 percent cut, even though odds of a deeper cut fell to zero. So, the Fed didn’t want to throw markets a curveball.
Another factor occurred across the pond last week, when the European Central Bank lowered interest rates again and unveiled a stimulus package to boast the Eurozone economy. If central banks around the globe are growing more accommodative, there’s not much reason for the Fed to remain on an island.
“It would’ve been a mistake to do nothing,” says Schutte.
If we zoom out to the big picture, the Fed has shifted from an entity fighting inflation (its historic role) to boosting inflation in order to avoid a deflationary cycle that could trigger a recession. The Fed has set an average inflation target rate of 2 percent, but it hasn’t quite hit that goal yet. While the Fed is working to balance policy timing with the trade wild card, Schutte believes the Fed will do everything it can to get inflation to its target. Ultimately, Schutte says it’s important to remember that nothing in the data points to a recession right now.
“From a fundamental economic cycle perspective, there’s no reason to have a recession right now. That leaves a mistake by monetary policymakers—the Fed—or fiscal policymakers (the trade war) as the only two reasons to have a recession,” says Schutte. “We don’t think the Fed tightened too much last year and dropped the ball—they want this cycle to continue. That leaves the trade war, and we’ll see how that plays out in the coming weeks. For now, we think the ball is in President Trump’s court.”
Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. There are a number of risks with investing in the market: if you want to learn more about them and other investment related terminology, click here.