Reading the Fed's "dot plot"

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Fed Chairman Jerome Powell described the July interest-rate cut as a mid-cycle adjustment to policy, or a so-called "insurance" cut.

The U.S. Federal Reserve delivered on its widely expected quarter-percentage-point interest-rate cut at the July meeting. It was the first reduction since 2008 and came in response to slowing global economic growth and muted inflation. The central bank also ended its balance sheet reduction two months ahead of schedule.

Eight of 10 Federal Open Market Committee (FOMC) officials voted to lower rates. Two FOMC members dissented in favor of holding rates steady. At a press conference following the rate-setting meeting, Powell struggled to give a consistent message, reflecting some of the tensions within the FOMC, the different viewpoints on Wall Street, and President Trump's opinion about where rates should be headed.

No recession in the cards

On one hand, the economy is not doing badly at all; unemployment remains low, job creation is strong, and it's hard to panic about the pace of GDP growth. Although inflation remains low, there's no sign of deflation risk returning. Recession does not seem to be around the corner. Financial markets don't appear to be under stress. Therefore, it was not surprising that there were people on the FOMC prepared to argue there was no need to change policy.

On the other hand, the state of the economy today reflects past policy decisions. We have never really understood why the current state of the economy gets so much attention from Fed watchers. What matters is the likely evolution of the economy, the forecast, and the risks. Today's policy influences the trajectory of the economy, not its current health. With global growth set to ease further and with continuing trade policy uncertainty, the risks seem asymmetric to us.

Mixed messages from Powell

There was little doubt that the Fed would cut rates at the July meeting. The uncertainty was over the messaging around the move and the likely direction of policy for the rest of the year. In this area, Powell was slightly more hawkish than many expected. He strongly discouraged the idea that a new easing cycle had begun. While this was coupled with the usual language about being ready to change, the decline in equity markets and the rise in the dollar were clear indications the message was taken as a bit hawkish.

This gets us back to the fragility of the current conjuncture. It's not so much that the economy looks to be in a particularly difficult place; growth is fine, and the downside risks — while certainly present — are far from life-threatening. A 25-basis-point move up or down at the front end of the Treasury yield curve is not going to have a large impact on the economy.

The bigger issue is whether current asset market valuations are consistent with the likely trajectory of the global outlook or whether they rest on optimistic assumptions about economic policy. Put another way, is Fed policy likely to be enough to end the inversion of the yield curve? Are corporate securities priced to reflect the most likely trajectory of the global economy, or do current prices assume a much lower path of policy rates and a more benign trade policy outcome than are likely? Is this cut "one and done," or will more be required?

Whether this reduction will be the start of a full easing cycle or ends up being an insurance cut will depend on how the global economy evolves.

Powell described the rate cut as a mid-cycle adjustment in policy, a so-called "insurance" cut. Note that this labeling is done with the benefit of hindsight; the first interest-rate reduction almost never looks like a recession cut. Whether this cut will be the start of a full easing cycle or ends up being an insurance cut will depend on how the global economy evolves.

Goldilocks scenario gets harder

The Fed is trying to keep the current version of Goldilocks going, but it's getting harder and harder. A Goldilocks scenario typically refers to a combination of low inflation, steady interest rates, rising corporate profits, and strong economic growth.

The Fed has indicated that it is worried about weaker global growth, trade tensions, financial market volatility, and domestic business spending. While markets were trying to make sense of the Fed's rate move, the Trump Administration — apparently frustrated by the lack of concessions from China in the trade talks — threatened to impose 10% tariffs on $300 billion of Chinese imports. President Trump backtracked in mid-August and delayed tariffs on electronics and other consumer products made in China to December. He also excluded other imports from the tariff list entirely. The duties were set to go into effect in September.

Still, we are nervous that the current configuration of rates, the economy, and risky asset prices is not sustainable.