Research

Economic Insights: Message received loud and clear

Rate cuts almost seem inevitable, but they may produce unintended consequences

June 26, 2019

The Fed seems concerned about two key things: (1) inflation remaining too low, even as some members believe transient factors are holding down inflation, and (2) trade-related risks.

Message received loud and clear

If the Fed intended to signal a likely reduction in interest rates, it certainly succeeded. Although the Fed left rates unchanged last week, it rather aggressively signaled that multiple rate cuts should arrive this year -- an abrupt reversal from last autumn, when it was signaling multiple rate increases for 2019. The Fed seems concerned about two key things: (1) inflation remaining too low, even as some members believe transient factors are holding down inflation, and (2) trade-related risks. As expected, publicly-traded markets responded favorably to the Fed’s signal with asset market indexes, including debt and equity, hitting all-time highs.

We do not yet know the exact timing and form of monetary loosening currently. Markets expect a cut of 25 basis points next month, but it remains uncertain whether the U.S. and China will reach a trade accord at the G-20 meeting this coming weekend. We have never resided in the grand détente camp on U.S.-China trade and do not see a high probability of an agreement this weekend. 

Therefore, we expect the Fed will likely cut rates in line with futures market expectations. 

Most likely, the two sides could show small progress toward a larger resolution, including the possibility of further meetings and negotiations. Therefore, we expect the Fed will likely cut rates in line with futures market expectations. The Fed could also possibly alter its efforts to reduce the size of its balance sheet by either halting sales or even reverting to purchases. To be fair, the Fed maintains company in its dovish stance with others including the European Central Bank (ECB), which also signaled last week that it could loosen monetary policy if needed.

economic-insights

Though there are some risks of further slowing, we do not yet see slowing excessively falling below our expectations for 2019 and 2020

We see four key issues with the Fed’s dovish stance:

  1. Are these cuts needed? Thus far, we have seen only some indications of a deterioration in aggregate demand. Though there are some risks of further slowing, we do not yet see slowing excessively falling below our expectations for 2019 and 2020. Deterioration centers in manufacturing more than services, which befits an economy involved in a trade war. And research (ours as well as others) shows that these kinds of rate cuts can put off but not prevent a recession, while in the process, making the recession that ultimately arrives worse than the one that would have arrived sooner.
  2. Are markets assuming the Fed will come to the rescue? The response from public markets sure seems so, but we have previously mentioned the limited impact monetary policy holds.  Are markets expecting too much? In addition to indexes hitting record highs, nominal debt levels are also reaching record highs. In the past, such developments have exacerbated downturns.
  3. Has the Fed undermined its credibility? To an extent, this appears true. With the Fed altering its stance faster than it is altering even its own economic outlook, it is risking its credibility. While we acknowledge downside risks have increased, what happens if the Fed cuts, these risks don’t materialize and the economy keeps growing above potential? Do they reverse course again on rate increases?
  4. If rate cuts happen, what is next? If the Fed follows the market and cuts two or three times over the next two to three quarters, that will leave the target fed funds rate at or below two percent. What happens if they cut and cannot increase rates before the next recession? On average, the Fed typically cuts rates 500 basis points heading into a recession. 200 basis points leaves them with less than half the usual firepower and increases the likelihood that they must resort to alternative measures such as quantitative easing, negative interest rates and forward guidance, which research shows has a less likely impact in blunting the severity of a recession than cutting rates.

Data still firm, but what are the surveys saying?

As we mentioned, the underlying data still signals solid, if slowing economic momentum, in line with our general expectations. What are the surveys saying? They are worth examining because souring sentiment could impact future behavior. Thus far, consumer sentiment remains at very high levels. Most of the business confidence surveys also show elevated levels, even if down slightly from recent highs. While we would prefer to wait and see exactly how underlying data and sentiment change, we do not think the Fed will wait very long before moving on rates.

What we are watching this week

Inflation sits as the key release this week. Inflation measured by the personal consumption expenditures (PCE) index for May should show that headline and core prices increased slightly. On a year-over-year basis, that likely means no charge, or possibly a slight weakening in inflation, which should further embolden those in the dovish camp. We will also closely watch the G-20 summit for any indications that trade tensions are easing, though we will not overreact regardless of the outcome.

What it means for CRE

Many in the commercial real estate (CRE) world cheered the outcome of last week’s Fed meeting. Yet, our research and others’ make us feel unsettled about the results. In the short run, cutting rates 50 basis points this year and another 25 next year (which now seems plausible) could provide a slight boost to the economy and CRE fundamentals, but cutting could also engender asset bubbles. Markets already sit at or near record-high levels, while cap rates hover at or near record-low levels. Do CRE fundamentals and the current economic outlook justify this bullishness, or does it stem simply from a change in outlook in monetary policy? Seems more likely the latter than the former. This enthusiasm could certainly provide a shot in the arm for transaction volume this year, even at such lofty price levels. The CRE debt market could also get some wind in its sails from lower rates. But increasingly, this time does not feel different and harkens to cycles past that did not end well. Near-term gain for long-term pain? Possibly.

Thought of the week

The median age for an American was 38 in 2018, up from 37 in 2010 and 32 in 2000.
Note: We will not publish Economic Insights next week but will return after the holiday weekend in the U.S. with our quarterly global Economic Outlook. Have a safe and happy Independence Day!