The Federal Open Market Committee (FOMC), the Fed’s policy-making group, announced today a 25 basis point reduction (-0.25%) in the Fed Funds rate, to a new trading range of 1.75-2.00%. This follows a similar cut in the rate in July, which reversed Fed interest rate policy and was the first cut in over a decade. The FOMC statement was cautious regarding policy going forward and indicated a split committee on further cuts in the Funds rate.
The old saw in the bond market is that if the Fed would just keep the Fed Funds rate closely aligned with market rates it will get monetary policy right most of the time. The corollary observation is that long-term interest rates reflect changing liquidity conditions in real time and the Fed usually moves the Funds rate up or down accordingly after some deliberation. The bond market has been signaling for months that Fed policy is too tight and short-term interest rates need to come down. Fed Funds futures markets are projecting a Funds rate one year out about 70 basis points lower than where they are this afternoon.
So it was widely expected that the FOMC would announce a 25 basis point drop in the Funds rate today at the conclusion of their regular meeting. The notable thing about the Fed’s reversal from raising the Funds rate last year to cutting it this year is that the U.S. economy appears relatively healthy and isn’t exhibiting strains indicating a serious liquidity squeeze or a need for Fed intervention. U.S. growth has slowed from last year’s fairly robust 3.0% growth in Real Gross Domestic Product to a more modest pace in the 2.0-2.5% range this year. 2% is about the average rate of real growth since 2009, so U.S. growth has only reverted to trend, which in prior cycles would not make a strong case for Fed easing.*
The difference this year is that global growth is slowing, getting to the point of elevated concern in Europe that has prompted the European Central Bank (ECB) to reinstitute a quantitative easing (QE) program, having only terminated their prior four-year, $3.0 trillion program of QE last December.* The previous program produced no notable achievements, inflation never accelerated much, if any, above 1%; and Eurozone economic growth barely got to a 2% rate last year before the trade war took wind out of European sails and growth decelerated back toward 1%.* Markets have been anticipating the ECB’s move to asset purchases, which is a big part of the decline in long-term interest rates globally, and the re-emergence of widespread negative interest rates in Europe.
The Fed’s messaging after the FOMC meeting was mixed, with reassurances that the Fed will provide support to the economic expansion as needed offset by the projections that, on a mid-point of survey basis, known as the “dot plots,” the FOMC collectively thinks it has it just right with an average Funds rate of 1.88%, now and throughout 2020.* That was a discordant melody for the markets, which have clearly expressed an expectation of further cuts in the Fed Funds rate. Interest rates rose 5-10 basis points after the announcement, more in the short end than long, the Dollar rallied and broad U.S. equity markets declined 0.4% before recovering at the close. Our view is that the Fed will eventually cut the Funds rate further to better align with the Treasury bond market.
*Source: Bloomberg Finance, L.P.
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