Why the Fed may not cut rates in July

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The dot plot showed the Federal Open Market Committee evenly split between cutting and holding rates, but it's not clear whose dots are whose.

The market is expecting the Fed to cut rates by at least 25 basis points at its July 30-31 meeting. Of course, listening to Fed officials you get the impression they’re not in a rush to make any moves. And, before the previous Fed meeting, some market observers were skeptical that a cut would come soon.

Of course, Chair Jerome Powell and Vice Chair Richard Clarida have repeatedly stated they will “act as appropriate” to maintain the expansion, while noting the uncertainty about trade and the slowing global economy is the question going forward, as the U.S. economy hums along. They have not suggested a time frame.

“The current uncertainty around the economic outlook poses some challenges for policymakers,” Federal Reserve Bank of Cleveland President Loretta Mester said Tuesday, according to prepared text of a speech released by the Fed.

While the release of a weak nonfarm payrolls number on Friday could indicate the start of a weakening in labor markets, Mester said she would need to see “a few weak job reports, further declines in manufacturing activity, indicators pointing to weaker business investment and consumption, and declines in readings of longer-term inflation expectations,” to convince her “that the base case is shifting to the weak-growth scenario.”

Last week, speaking in New York, Federal Reserve Bank of San Francisco President Mary C. Daly also suggested it would take six to eight weeks of data to assess whether the economy will need more accommodation or whether these headwinds will pass.

Neither president currently has a vote on monetary policy.

One voter, Federal Reserve Bank of St. Louis President James Bullard is on record in favor of a 25 basis point cut, having dissented at the latest FOMC meeting where rates were held at 2.25% to 2.5%. Federal Reserve Bank of Chicago President Charles Evans said in a televised interview last month, when asked why the markets are pricing in two rate cuts this year while the Fed sees none, said, “it suggests the market sees something that I haven’t yet seen in the national data.”

Evans, a voter this year, is a dove.

Federal Reserve Bank of Boston President Eric Rosengren said in May, “I see no clarion call to alter current policy in the near term.”

Although Mester, in her speech, pointed to international trade policy uncertainty and political tensions in the Middle East as something to monitor, she noted, “throughout this expansion, the U.S. economy has proven itself resilient to a variety of economic shocks, headwinds, and uncertainties. We have seen similar episodes of soft data and sentiment that subsequently reversed.”

And, if the economy does withstand the headwinds, "there is still a question of how the Fed should react to the lower inflation readings we’ve seen in recent months,” Mester said. “Some would argue that lowering the funds rate would be appropriate in an attempt to push up inflation expectations. However, if it is the case that nonmonetary structural factors holding back measured inflation, thereby putting downward pressure on inflation expectations, rather than an aggregate demand problem, it is not clear how effective this policy would be. Cutting rates at this juncture could reinforce negative sentiment about a deterioration in the outlook even if this is not the baseline view, and could encourage financial imbalances given the current level of interest rates, which would be counterproductive.”

She pointed to the 2014-2016 economic slowdown when the Fed “was patient” raising rates only in December 2015 and December 2016, “allowing inflation to gradually move up.”

“So long as the sustainable-growth scenario of continued expansion and strong labor markets remains the baseline outlook, I would favor taking a similar opportunistic approach to the recent softness in the inflation readings instead of trying to proactively move inflation up with rate cuts,” she said.

With so much uncertainty about the outlook, Mester said she’s not surprised by the various views of FOMC panelists.

“The Fed’s decision to cut rates hinges on two issues,” according to Bryce Doty, senior vice president/senior portfolio manager at Sit Fixed Income. Whether the weakness is temporary and whether a rate cut would “offset and directly solve fiscal/trade policy decisions.”

The one piece of data released Tuesday, the Institute for Supply Management-New York’s report on business, showed current conditions at the 50.0 break-even level in June after a 48.6 contractionary reading in May.

But the six-month outlook dropped to 51.0, its lowest reading since a 50.7 level in May 2009.

The quantity of purchases index slumped to 34.2 in June from 56.6 in May to 34.2 in June, its lowest reading since 31.8 in July 2009.

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Monetary policy Economic indicators Manufacturing industry Loretta Mester Federal Reserve Federal Reserve Bank of Cleveland FOMC