Federal Reserve Chairman Jerome Powell’s remarks in Jackson Hole last week broke little ground. They confirmed what the market already expects – a 25 basis point (bp) cut in the federal funds rate in September – but stopped short of hinting at further easing. What’s more, various current and former FOMC (Federal Open Market Committee) officials raised the prospect of a slower (or no) response. We think a more aggressive approach will be needed to mitigate the risk of recession in the U.S.
We believe so, in part, because recent economic data may understate the extent to which the economy is slowing. In particular, recent revisions to labor market indicators suggest momentum has decelerated more than we had been expecting. Strength in some demand indicators could reflect a temporary surge as firms and consumers race to get ahead of potential increases in import tariffs.
Given the lag between changes in interest rates and economic activity, we believe the case for easing is strong. Indeed, following next month’s 25 bp cut, we expect further easing later this year. Even with these additional cuts, though, we think economic growth could slow to a below-trend pace and prompt the unemployment rate to rise over several subsequent quarters.
Deep divisions on the near-term path for policy
While Powell’s remarks were sufficient to confirm the current market pricing of a 25 bp rate cut in September, they also reflected divisions among members of the FOMC on the appropriate near-term path of monetary policy and raised questions about how quickly the Fed is willing to react to the deteriorating outlook.
For example, on one hand Powell continued to see the U.S. economy performing well, while on the other he noted “significant” downside risks that may call for further easing. Similarly, the “mid-cycle adjustment” language was notably absent from this speech, but Powell downplayed hints of more aggressive cuts by saying that policy may only need to “tilt” toward easing. Finally, when speaking about trade policy, he stated that monetary policy can “try to look through what may be passing events,” while in the same sentence promising to focus on how trade developments are affecting the outlook and adjust policy as necessary.
The various regional Fed presidents’ communications further underscored the range of views. On one side, Philadelphia Fed President Patrick Harker presented the case for no further easing, while Dallas Fed President Rob Kaplan said he was “open” to further cuts, and St. Louis Fed President James Bullard called for a “robust debate” of the merits of a 50 bp cut at the FOMC’s next meeting on September 17–18.
Misguided arguments against easing?
FOMC participants opposed to further rate cuts make the following arguments: 1) Consumption, which is two-thirds of the economy, is solid, 2) monetary policy should be cautious about overreacting to elevated trade tensions that can die down as quickly as they escalated, and 3) lower rates raise financial stability risk. We think these arguments are misguided for a few reasons.
First, while we generally agree that household balance sheets are healthy and consumption growth staged a solid rebound in the second quarter, we can’t emphasize enough that labor market momentum has decelerated more markedly than most forecasters were previously expecting. Recently released preliminary benchmark revisions from the Bureau of Labor Statistics suggest that the monthly pace of payroll gains is closer to 120,000 (versus the roughly 225,000 pace this time last year), just slightly above the pace needed to keep the unemployment rate steady. Slower payroll gains have coincided with fewer weekly labor hours, which will reduce growth in aggregate incomes and consumption and make the economy more susceptible to negative shocks.
Second, the Trump administration has given little indication of backing down from further provoking China, partially on the premise that trade policy is having little effect on the U.S. economy (after all, real GDP growth averaged 2.6% annualized in the first half of the year). We think this is the wrong premise, as real growth was likely temporarily supported by inventory stocking to mitigate costs ahead of tariffs. We also worry that when a slowdown becomes obvious in the headline data, it will be too late.
Third, while asset valuations across various markets are elevated and corporate leverage is historically high, household debt is modest by historical standards, the banking sector is better capitalized, and funding risk is low. And while it’s possible that lower rates contribute to financial market excess over time, we think this risk is manageable. The elevated levels of business uncertainty aren’t likely to sow the seeds of irrational exuberance and bubble-like behavior.
We aren’t so sure that the U.S. economy is “in a good place” and view recession risks as sufficiently worrisome to warrant further Fed easing. We expect next month’s 25 bp rate cut will be followed by more rate cuts by the end of the year. Ultimately we think FOMC participants will provide the support, but recently have become more worried that the support won’t come soon enough.
Explore our latest thinking on interest rates and their investment implications.
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.