As was widely expected, the Federal Reserve on Wednesday announced another quarter-point cut in the policy rate (down to 1.50%–1.75%) – the third such cut in as many meetings – along with a parallel downshift in the rate of interest on excess reserves (IOER) to 1.55%.

The surprise for markets was in Fed Chair Jerome Powell’s press conference statement that monetary policy is “likely appropriate” at today’s level barring “material” deterioration in the outlook, which we interpret to mean that further so-called insurance cuts are unnecessary. Instead, more accommodation is now contingent on a more material deterioration in the economic outlook.

Still, it may not be a particularly high bar for the Fed to downgrade their outlook, since their 2% 2020 growth forecast is currently above both consensus (1.7%) and PIMCO’s forecast (a 1.25%–1.75% range). Therefore, despite the messages from Wednesday’s meeting, we think more accommodation may still be needed in the quarters ahead.

Interpreting the Fed’s hawkish messages

Despite the more hawkish messages on easing in Powell’s prepared remarks, his comments were more balanced during the Q&A. He focused on lingering downside risks to the economy, while suggesting that the bar for rate hikes is quite high. According to Powell, “We would need to see a really significant move up in inflation that’s persistent before we would consider raising rates.”

Overall, we believe the bar for further cuts is much lower than that of hikes, and a prolonged period of steady rates is predicated on an outlook that we believe may be too upbeat.

Changes in the Fed statement were modest but hawkish: Prior statements said the Fed “will act as appropriate to sustain the expansion”; this was changed to “will continue to monitor … the economic outlook as it assesses the appropriate path” for the policy rate (emphasis ours). This suggests a shift away from immediate action.

Why markets may be underpricing the likelihood of additional cuts

Despite the hawkish shift at Wednesday’s meeting, we think it’s likely that the economic data over the next few quarters may justify additional accommodation.

• While Powell expressed optimism that trade developments have moved in a “positive direction,” the recent (and perhaps temporary) U.S.-China "trade truce" doesn’t materially change PIMCO’s near-term outlook. For one thing, the September tariffs weren’t rolled back, and we are only now starting to see the effects in the economic data. Furthermore, delaying the tariff hike scheduled for December appears contingent on Chinese purchases of U.S. agricultural products that have yet to materialize.
• Also, global trade and industrial production growth haven’t obviously bottomed, which argues for U.S. investment and export growth to weaken somewhat further. And while third-quarter headline real U.S. GDP growth remained slightly above trend at 1.9%, the details were weaker. A likely one-time surge in auto production contributed almost a full percentage point to growth – the strongest contribution since 2009 – whereas other areas were weaker.
• Real consumption growth is still likely to slow over the coming quarters as lower corporate profits weigh on labor market momentum, aggregate incomes, and real consumption. Based on company reports, earnings of public companies in the S&P 500 are likely to have grown only 2% year-over-year in the third quarter – down notably from the over 10% pace in 2018.
• U.S. inflation has remained below the Fed’s long-term target of 2% (as measured by personal consumption expenditures or PCE), suggesting the potential cost of somewhat more policy accommodation is low.

Taken together, we think some further weakening in the U.S. economic data may cause Fed officials to downgrade their outlook and markets to price in a higher risk of further rate cuts over the next several quarters. However, ultimately growth will likely bottom as the lagged effects of global central bank and fiscal policy easing should help stabilize growth in the second half of 2020.

Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.