Fed meeting preview: rate cuts now a given?

Slowing labour market means rate cut likely

It looks like the Federal Reserve (Fed) will cut rates this month, but those hoping for a 50-basis-points (bps) cut are likely to be disappointed.

The most recent set of non-farm payrolls (NFP) put a spanner in the works when it comes to expectations surrounding the next Fed meeting. Before the monthly jobs report was released, there was a 25% chance that the Federal Open Market Committee (FOMC) would cut rates by 50bps. After the data came out, that figure dropped to just 2.5%.

Approximately 224,000 jobs were added in June, a significant improvement over May, and wage growth remained steady. However, the general trend of a slowing labour market remains, and this is a key plank in the rate-cut argument. There were no upward revisions to previous months’ reports in the latest NFP update, a sharp contrast to the May report which contained downward revisions to previous monthly figures.

Wage growth is beginning to disappoint as well, providing another reason for caution regarding the economic outlook. It is difficult to envisage a scenario in which falling wages help to boost inflation, suggesting that the Fed will struggle to hit its target for price increases.

Notably, James Bullard, St Louis Fed president, said that a 50bps move would be overdone, and that any cut in rates would be a form of insurance to help nudge the economy back on to the correct path. Fed chairman Jerome Powell, too, sought to cast doubt on the idea that a dramatic move was coming, arguing that the FOMC should avoid overreacting to any one piece of data.

Fed focusing on economic expansion as well as fighting inflation

An interesting development in the previous Fed meeting was a focus on maintaining the economic expansion, rather than merely fighting inflation. By ensuring that the economy continues to grow at a steady pace - with low inflation - the benefits of secure employment can flow through to more people, boosting the economy yet further. The Fed has often been criticised for hiking rates until the economy tips into a recession, so the more dovish approach here is designed to avoid that.

US President Donald Trump’s appearance before lawmakers in mid-July has reinforced the expectation that a rate cut is coming, but he was careful not to err too far on the dovish side. Some would have liked him to go further, but the message from the Fed appears to be that 25bps is enough, and that a bigger move would require further economic weakness.

Unsurprisingly, investors had become overexcited in the wake of the last meeting, expecting dramatic action from the Fed. It is easy to see why European Central Bank (ECB) president Mario Draghi had given a speech that would seem to indicate that the ECB would ease policy in a potentially significant way at its next meeting in order to respond to the anaemic state of the eurozone economy. The June FOMC meeting followed on from this, and came after the Reserve Bank of Australia (RBA) had cut rates too. This dovish shift carried echoes of the financial crisis, when central banks moved together to ease policy to help counter the crisis.

But 2019 is not 2008. The US economy continues to post healthy, if unspectacular gross domestic product (GDP) numbers, while outside of manufacturing American businesses are still enjoying growth, and retail sales and income tax receipts - both indicators of economic growth - are also rising. A rate cut in July is more about reversing the increase of December 2018, and anything more than 25bps would likely be an overreaction. Job growth is still solid, but if it were to weaken further, then another cut might become necessary.

Trade wars are still a threat, and while the US and China have hit the ‘pause’ button on fresh tariffs, and have committed to restarting negotiations, those have yet to take place. If the conflict returns later in the year, or spreads to a US-Europe spat, then the case for rate cuts will be given another boost.

The Fed is not about to revive the easy monetary policy of the post-crisis years. The strategy now is to manage the economic expansion to avoid provoking a recession. Thus the July meeting will likely see a rate cut, but not one as dramatic as previously expected.