Fed Policy After a 25 BP Cut

With a 25 BP rate cut by the Fed at the September 17-18 FOMC Meeting a near-certainty, the markets will be looking for any hint that this is the last easing for awhile.  This will be found in the "dots" chart, which will be updated along with the Fed's economic projections at this meeting.

The chart shows what the FOMC participants -- board members and district bank presidents -- expect the funds rate to be in 2019-2022.  It is an explicit statement of what officials think the most likely path of the funds rate will be.  Nevertheless, the chart is no guarantee of being a correct prediction.  For example, at the December 2018 meeting, it showed expectations for an upward path of the funds rate over the next 3 years.  The Fed stopped tightening the following month.

Because the Fed is now basing monetary policy on downside risks to the outlook, there is even greater-than-normal uncertainty about the reliability of the dots chart.  These risks are difficult to ascertain, as they can be subject to the eyes of the beholder.  Powell and other Fed officials have been citing downside risks at the same time as portraying economic growth to be solid.  The latter view could seem to undercut the significance of the former.  And, he has varied the litany of downside risks over time.  So, as the headlines and data shift, the question will be whether the Fed's perception of downside risks have changed enough to affect their policy decision. 

The key to answering this question may be the markets' own behavior.   Since officials, themselves, are likely unsure how to evaluate the significance of any specific data or event in terms of downside risk, they may continue to rely on the markets' reaction to make policy decisions.  If longer-term yields climb and the curve steepens in response to new information, the Fed could pull back from its concerns about downside risks.  A breakthrough in the US/China trade talks or new German fiscal stimulus are potential examples where yields could rise (led by European yields in the latter case) and the dollar falls.  The extent and persistence of these moves presumably will be important regarding their impact on Fed decision making.  But, if such developments do not result in these market moves, then further Fed easing may remain a good possibility.  If the markets don't think an event or data significantly affect the risks to the outlook, why should the Fed. 

This week's US economic data are not expected to affect the Fed's concerns about downside risks.  Consensus looks for a small 0.1% m/m increase in August Ex Auto Retail Sales, which would be decent after the 1.0% jump in July and the likelihood of some unwinding from "Prime Day" in July.  Consensus also looks for a moderate 0.2% m/m increase in the July Core CPI, with the y/y edging up to 2.3% from 2.2%.

US economic data will be important in 3 cases.  One, if they show that GDP Growth is well above or below the 1.8-2.0% long-run potential pace for an extended period.  Two, if core inflation is very high or low relative to the Fed's 2% target.  Three, if Fed officials shift to viewing 3.0% growth as a long-run potential pace rather than their current estimate of 1.8-2.0%.  To date, they have not done so.