Fed Should Pause After This Week's Rate Cut

Last week's Treasury market sell-off is a signal to the Fed that monetary policy should take a breather after a 25 BP cut at this week's FOMC Meeting.  Parts of the yield curve reversed their inversion (longer-term yields lower than shorter-term yields), suggesting some of the downside risks to the outlook have eased.

News stories suggesting some kind of breakthrough in US/China trade negotiations in October reduce the downside risk to the US economic outlook.  And, the ECB rate cut works against the downside risk from the global slowdown.  As for other risks, the Saudi shutdown of 50% of its oil output after the drone attack has mixed implications for the US economy and, on balance, should have a small impact.

A 25 BP cut this week is probably still in the cards, despite the optimistic news regarding US/China and higher inflation data for August.  It is still not clear whether the negotiations will be concluded.  And, the higher August core inflation prints were narrowly based.  Historically, the Fed tends to overshoot when either easing or tightening -- possibly a requirement to be effective.

Core inflation may have bottomed, as the Core CPI rose an above-trend 0.3% m/m in the past two months and pushed the y/y up to 2.4%.  But, the speedup was not widespread.  Large increases were registered in Hospital Services, Health Insurance Premiums and Airfares.  Most other components were little changed or lower.  And, some important components, like Owners' Equivalent Rent, in fact, slowed.  So, the run-up in core inflation may be temporary.

To be sure, Non-Fuel Import Prices were flat in July-August, after falling in 5 of 6 months in H119.  So, they may be less of a drag on inflation ahead.  Also, Average Hourly Earnings posted a high 0.4% m/m increase in August.  But, some of the strength likely reflected calendar considerations that should moderate in September.

The real-side of the economy is rising moderately.  It does not justify Fed easing, but does not stand in its way.  Q319 Real GDP Growth, at 1.8% according to the Atlanta Fed model's latest forecast, is in the range estimated by the Fed to be the economy's long-run potential growth rate.  It is neither too high or too low.  While job growth slowed sharply in August, early evidence points to a speedup in September.   

The cutback in Saudi oil production has mixed implications for the US economy.  Oil prices are expected to jump by as much as $10/bbl, depending on the length of time of the cutback.  This would translate into as much as 23 cents/gallon for gasoline.  Along with higher heating costs, consumers will have to pay an additional $35 Bn (annualized) directly with a $10/bbl jump.  Total US spending on petroleum products would climb by as much as $75 Bn (0.4% of GDP).   But, more than half of this spending would be on domestically-produced oil, which should climb (both production and drilling) in response to the higher prices if they look to be in effect for some time.  So, the net effect of the higher oil prices on US GDP should be minor.

The "dots" chart to be released at this week's FOMC Meeting probably loses importance after last week's Treasury market sell-off.  The FOMC members' rate projections were done a couple of weeks earlier.  So, they might have incorporated concerns about downside risks to the outlook that now look less threatening according to the market (see my last week's blog).