How Far Will the Fed Ease?

With Fed Chair Powell opening the door to a 25 BP July rate cut by more than expected, the latter is now a near certainty.  However, with the US economic data beginning to strengthen in June, the need for additional rate cuts could become questionable in the markets.  So, the risk is that the odds of another cut this year will come down.

The issue is whether GDP growth will be below 2.0% in H219, as some Street economists predict.  Sub-2.0% growth would justify more than one easing.  Above-2.0% growth would raise doubts on the correctness of such policy, unless inflation remains subdued. 

The Fed staff, itself, has become more pessimistic about growth in the second half of the year.   According to the June FOMC Minutes, the Fed staff forecast Real GDP Growth "to slow to a moderate pace in the second quarter and move down to a more modest pace in the second half of the year, primarily reflecting a more downbeat near-term outlook for business fixed investment."  The Fed staff is not necessarily correct, so upcoming US economic data remain important for the markets to evaluate how GDP growth is evolving.

Another issue for the Fed and markets is whether inflation will speed up.  Powell was quick to agree that the Phillips Curve -- the model that relates inflation to unemployment and inflation expectations -- no longer works.  But, the announced "death" of the Phillips Curve may be premature.  NY Fed President Williams pointed out a few months ago that the inverse relationship between inflation and unemployment could resurrect itself at very low levels of the unemployment rate, which the US is not far from.  Also, some major components of inflation, such as rent, could move up independently of the unemployment rate.  For example, news stories have recently discussed how Millenials prefer to rent a home rather than purchase one.  A shift toward rentals could boost rents for awhile, until supply responds.  Curiously, a Fed tightening in response to a rent-induced speedup in inflation could worsen the latter, as more people shift to renting from home buying as mortgage rates rise.

Powell cited downside risks from weaker foreign growth and business uncertainty stemming from US/China trade negotiations.  So, upcoming non-US economic data and US business investment data are the most relevant regarding the Fed's concerns.  Some of these data will be released later in the month, including the Markit Purchasing Manager Indexes and June Durable Goods Orders.  Next week's consensus expectation for modest increases in June Retail Sales and Manufacturing Output should not shift market views of the Fed.  But, stronger-than-consensus prints, along with evidence of stronger residential construction activity could spark talk that the Fed will pause after a June cut.