The Federal Reserve cut rates by a quarter-percent on July 31, the first rate cut since December 2008. Financial markets reacted with collective disappointment — stocks fell, bond yields fell and the dollar strengthened. The 3-month/10-year yield curve remained inverted and the 2-year/10-year yield curve flattened significantly.
Fed Chair Jerome Powell’s somewhat “wobbly” press conference created more confusion for market participants. Equities fell sharply after Powell’s initial comments, then partially recovered after Powell softened his initially hawkish tone. President Donald Trump was quick to criticize the Fed’s decision, a continuation of his apparent strategy to make Powell the scapegoat for slowing economic growth. Five takeaways from the Fed’s decision may provide insight into the future path for monetary policy:
1. Powell may be willing to defy Trump, but he is less likely to defy markets. Powell characterized the Fed’s move as a mid-cycle adjustment to policy rather than the start of a long series of rate cuts. Powell subsequently clarified his initial comments by pointing out that he wasn’t implying that the Fed would be “one and done” after the July cut. According to Powell, further cuts will be dependent on incoming data and evolving risks to the outlook. Slowing economic growth and rising trade tensions makes it likely that more than one “insurance” rate cut will be necessary. Powell might ignore Trump’s rhetoric threatening the Fed’s independence, but he is not likely to ignore signals from financial markets. The next cut may be as soon as September, given the market’s “verdict” on the Fed’s decision, Trump’s announcement of a new 10% tariff on $300 billion of Chinese goods effective Sept. 1, and worsening yield curve dynamics.
2. The Fed plans to end its balance sheet reduction process two months early, which may be more important than July’s rate cut. The effective end to quantitative tightening is a signal that the Fed’s balance sheet is back in play as a potential mechanism to support a faltering economy. By rolling over maturing Treasury holdings and reinvesting proceeds from maturing mortgage securities into Treasury debt, the Fed could ease financial conditions by more than the one-quarter percent cut in the federal funds rate. Based on the projected cash flows from the Fed’s mortgage portfolio, the Fed will be a significant net new buyer of Treasuries to help fund the federal deficit in the coming year. Fed purchases of Treasuries could play an important role in normalizing the yield curve.
3. Fed policy is increasingly influenced by conditions outside the U.S. Powell discussed economic conditions outside the U.S. in his press conference, noting the slowdown in economic growth in the EU and China. U.S. manufacturing activity fell close to three-year lows in July, evidence of the impact of trade tensions and slowing growth outside the U.S. S&P 500 earnings and revenue growth were relatively weak in the second quarter, with multinational companies among the hardest hit by trade tensions and the strong dollar.
4. Central banks can’t solve the world’s economic problems by themselves. The Fed and European Central Bank are setting the tone in a world in which central banks implement expansionary monetary policies. However, the equity selloff after Trump’s latest tariff announcement is a reminder that monetary policy isn’t a universal cure for what ails the global economy.
Trade policy is the primary cause of slow business investment, not the cost of capital. The latest round of tariffs will hit U.S. consumers harder than any prior trade actions, underlining the diminishing effectiveness of tariffs as a policy instrument. Worst-case outcomes on trade would have a direct bottom-line impact for many companies and impose significant costs on companies forced to reconfigure their supply chains.
5. Powell has a delicate balancing act within the Fed. Kansas City Fed President Esther George and Boston Fed President Eric Rosengren voted to keep rates unchanged, with low unemployment and the rising stock market among the factors motivating their dissent. The Fed’s leaders also worry about the risk that if monetary policy is too expansionary, destabilizing imbalances will build within the financial system. The rapid buildup in corporate debt is certainly on the Fed’s radar screen, though the vast majority of corporate borrowing has moved from bank balance sheets to the balance sheets of unleveraged investors. Consequently, the level of corporate debt would likely amplify an economic downturn but is less likely to create a crisis in the financial system.
Closing thoughts. The Fed has been widely criticized for recent policy decisions and a frequently unsteady communication approach. Critics are on shakier ground, however, in challenging the seriousness of the Fed’s commitment to the dual mandate of maximum employment and price stability. The yield curve is an important barometer of economic health and the longer that inversion persists, the more aggressive that Fed actions will be to normalize the curve. With inflation continuing to fall short of Fed targets, the U.S. economy softening, global manufacturing in recession, and trade tensions heating up, a rate cut in September is likely.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.