The Fed gets the squeeze

| August 9, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The president and the market have something in common these days: both are putting the squeeze on the Fed. President Trump continues ratcheting up tariffs on China while blaming tight monetary policy for slowing down an otherwise robust U.S. economy. The market keeps pricing substantial future cuts and going into severe risk-off spasms whenever the Fed implies it might disappoint expectations. The Fed risks losing control of the monetary policy narrative, which could result in excessive market upheaval should the Fed eventually disappoints either market or presidential expectations for aggressive easing.

Financial markets: what’s the opposite of a bond market vigilante?

 There is a long history of the Federal Reserve’s monetary policy being constrained by outside forces. The Fed entirely gave up control of monetary policy during World War II as it bought bonds to support the war effort and did not regain independence until the Treasury-Fed Accord of 1951. Political pressure heavily influenced the Fed’s behavior in the early 1970s, exacerbating the extraordinary inflation experienced during the decade. Once their inflation-fighting credibility was lost, the Fed had to adopt an extremely tight stance to bring inflation back under control. Even after price increases slowed in the early 1980s, the Fed repeatedly faced inflation scares where any whiff of inflation led to huge leaps in long-term bond yields, forcing the Fed to pre-emptively tighten to satisfy the vaunted bond market vigilantes.

More recently, the Fed has been challenged to maintain control over its policy outlook. Despite a somewhat shaky start, the Fed’s effort to normalize both its policy rate and its balance sheet went pretty smoothly through 2018. The FOMC’s game plan was to push the funds rate target back up to and likely modestly through its consensus estimate of neutrality, which was at or just below 3%. Thus, the FOMC dots projections showed the Fed getting to a level of rates in the low-3% vicinity.

Financial markets were always a bit skeptical that the economy could bear such rate levels, but they were by and large dragged along for the nine rate hikes that took place after liftoff.  However, beginning late last year, the relationship between financial markets and the Fed became more antagonistic.  In the fourth quarter of last year, stock prices began to sag, and market participants started to question whether the Fed might be raising rates to levels that would restrain the economy.  The Fed carried on with its strategy through the December rate hike, which took the funds rate target to a 2.25%-to-2.50% range.

The severe risk-off trade in financial markets leading up to year-end spooked Chairman Powell and the Fed. In January, just weeks after it had hiked rates and projected two more increases for 2019 and one hike in 2020, Chairman Powell and the FOMC declared that the current rate setting was close enough to neutral. The upper end of the target range was 2.50%, the same as the lowest individual projection for long-run neutrality, and the Fed pledged to be patient going forward, signaling that further rate hikes were no longer the presumed option.

The bond market pressed its advantage, pricing in Fed easing later in 2019. In June, when the Fed acknowledged that lower rates would probably be necessary to account for heightened risks associated with trade uncertainty, the fed funds futures market proceeded to price in close to 100% odds of a 25 bp rate cut in July and, at times, significant odds of a larger move. The Fed seemed fairly content to take out insurance, though arguably the FOMC had little choice. It would have required a vigorous hawkish jawboning campaign to move the market off of its dovish pricing, which could easily have sparked another risk-off spasm akin to the late-2018 episode.

That dynamic appears to be in the process of repeating itself. Fed funds futures are currently pricing in a 25 bp rate cut in September as a virtual certainty. With markets skittish and trade uncertainty creating concerns about the global economic outlook, the Fed may feel compelled to once again follow the markets – whether it wants to or not.

Two rate cuts—one in July and one in September—would be exactly what roughly half of the FOMC had in mind in June based on the SEP projections.  The June FOMC dots showed eight participants wanted to hold policy steady this year, seven thought 50 bp of easing would be appropriate and one fell in-between. Market expectations differ, with Fed funds futures currently pricing in close to 100% odds of a third rate cut in October and better than a 50-50 chance of a fourth move at the December meeting. The markets’ voracious appetite for easing shows no sign of being satisfied by one more rate cut. The Fed has given an inch, and markets are now demanding a mile.

St. Louis Fed President Bullard offers an excellent example of how the markets have far outstripped Fed officials’ evolution on the rate outlook. A month or two ago, Bullard was one of the “good guys” to many nervous financial market participants, as he was among the first Fed officials to publicly call for a rate cut.  However, earlier this week, he noted that the moves taken by the FOMC had already accounted for trade policy uncertainty and that he was still in favor of a cumulative 50 basis points of easing this year, the same position he has had for several months. This time, the markets panned his comments as not forceful enough. Suddenly, someone who is one of the most dovish people on the FOMC is being labeled by financial markets as too hawkish!

President Trump and trade policy

Of course, the impetus for the latest leg down in interest rates and stock prices followed President Trump’s ratcheting up of tariffs on China. This is the other half of the pincer movement against the Fed. President Trump has been blaming tight Fed policy for slowing down an otherwise robust U.S. economy for some time.  His rhetoric has become more frequent and more vehement in recent weeks.  Whether intentionally or not, the administration’s trade strategy is putting additional heat on the Fed.

Many market participants have argued that President Trump is turning the screws on China in part to get the Fed to do his bidding. This narrative reflects the notion that President Trump wants the Fed to cut rates aggressively to boost the domestic economy heading into his re-election campaign, so he is stoking the trade spat now to force the Fed’s hand. A softer version maintains that the President’s leeway to press the trade negotiations depends in large part on the continued vigor of the U.S. economy and, to an extent, the stock market. If the economy begins to tank due to the souring of trade talks, then President Trump’s re-election prospects would most likely dim. As a result, he can push but must be careful not to push too hard. Most would probably agree that a certain amount of short-term pain to achieve the long-term gain of a broad trade deal with China would be a worthy trade-off, but probably not in the President’s mind if it costs him re-election.

Ironically, whether it wants to be or not, the Fed has become a central player in this equation. If the Fed responds to a deterioration in the trade talks by easing policy, then, to the extent that boosts the domestic economy or weakens the dollar at the margin, it actually gives the administration a little more wiggle room to pursue a hard line on trade. President Trump has at times been explicit about this trade-off in some of his tweets criticizing the Fed, exhorting the central bank to pitch in with aggressive rate cuts for the good of the economy/country.  In contrast, if the Fed were to draw a line in the sand and say that there would be no more easing, it would diminish at the margin the leverage of the trade hawks in Washington to aggressively pursue their version of the game of chicken with the Chinese.

What can the Fed do?

The Fed has three basic options in deciding how to respond to the pressures it faces from financial markets and President Trump.

  • Let the markets and Trump dictate. The Fed could defer to the collective wisdom of the financial markets and continue to follow the expectations reflected in fed funds futures. If policymakers determine that the economic expansion is in jeopardy as long as the trade negotiations are deteriorating, then the FOMC may decide that it simply cannot afford to disappoint markets and risk a subsequent tightening of financial conditions. The Committee could make a bet that President Trump wants a deal with China as part of his case for seeking re-election and would thus be inclined to settle with China, no matter how the economic outlook evolves, by early 2020.  If that were true, then it could be argued that there is probably a limit to how far and for how long the Fed would have to be easing and that it could always reverse course if necessary once a trade deal is secured.

There are obviously risks to such a strategy.  First, if the markets remain in a give-an-inch-and-they-will-take-a-mile mindset, then the Fed may find itself cutting rates by far more than it might otherwise prefer. Moreover, giving President Trump a degree of control over monetary policy has its own potential perils.  If the President sees that the Fed is pursuing such a gambit, then he might be inclined to hold off longer on seeking a deal with China, resting in the knowledge that monetary policy will be quite easy as long as the two sides fail to compromise.

  • This strategy might look a lot like what we heard from Bullard earlier in the week. The Fed will ease a couple of times to try to push inflation up to 2% and to insure against downside risks, but anything beyond that would require hard evidence that the economy is deteriorating by significantly more than the Fed expects. The message to the markets would have to be something like: “We’ll give you one more cut in September, but after that, the bar for additional easing gets much higher.” The message to President Trump and the administration trade team would be: “We have given you some help, but we are only going to do so much to enable your hard line. Going forward, you’re on your own.”
  • Play along for a while. This is the middle ground, or Strategy One for now, and Strategy Two later. Implementing the first two rate cuts would not create much discomfort among Chairman Powell and FOMC leadership, as half of the Committee was already calling for such a move in June, before the most recent ratcheting up of tensions with China. It may well be the case that recent events could justify a third rate cut for most of the more dovish Committee members.  Going much further than that might be too much, but the FOMC could certainly frame something like 75 bp of easing in the context of Chairman Powell’s “midcycle adjustment.” The two previous mini-easing cycles, in 1995-96 and in 1998, added up to 75 bp each. Anything much more than that would likely be excessive in the absence of hard evidence of sharp economic deterioration.

Unless the Fed wants to cede control of monetary policy entirely to external forces, it is going to have to shift gears at some point. The current focus is on downside risks and providing insurance as well as preserving easy financial conditions at all costs. Getting back to normal would mean transitioning back to a greater focus on the relatively upbeat base case for the economic outlook.  Whenever the Fed chooses to make that shift, it will not be painless. Chances are that the FOMC will need to create a gradual glide path from the current relatively passive approach to one in which it regains control of the narrative. At some point, the Fed will need to say that “the adjustment in policy this year addresses the downside risks, we’ve done enough, and the economy remains in good shape.”  It would probably be wise to begin communicating that shift early.  For example, if FOMC participants are thinking that the current landscape justifies one more cut in September, then officials would want to begin alerting market participants well before September 18 that this will probably be the “last one for a while” (or that determination could come later if the Committee is inclined to cut more deeply).

Financial market participants would probably put low credibility on such a message initially. After all, if the markets cornered the Fed into cuts in July and September, it would be natural to expect that if another easing is priced in for October, the Fed will have no choice but to go along again. Thus, starting early and taking time to smooth the path back to controlling the narrative will likely be necessary to get the Fed to a better place without excessive market upheaval.

Buckle up, a struggle for control of monetary policy is coming at some point, and it could get pretty difficult.

john.killian@santander.us 1 (646) 776-7714

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