The market has concluded that the Fed’s decision to keep rates steady, along with the accompanying statement from yesterday's meeting, is unreservedly dovish. The expectation is for two more rate cuts this year, starting in July. Markets are, unsurprisingly, cheering. Lower rates are good for economic growth and for stocks. In fact, that reasoning would explain why the Fed would cut. If the Fed does cut, it will be stimulative and should help sustain the expansion—as intended.
Indeed, we may get cuts. But before we join in the cheering, we should think a bit more about what those rate cuts might mean beyond an immediate boost to markets.
Real risks to the economy
The first concern is that, if the Fed does cut, it would be signaling that it sees real risks to the economy. Yesterday, Powell stated several times that the base case was for continued growth but that risks to that growth had risen. As dovish as the market deemed yesterday’s announcements to be, the Fed still thinks the economy is basically okay. If we do get a cut, it would mean the Fed has decided the economy is at real and immediate risk. Think about what that perspective might mean for markets.
The second concern is that, if the Fed thinks the economy is okay but cuts anyway, it will use some of its recession-fighting ammunition before it is really needed. Powell and company have been emphatic about how they needed to raise rates to prepare for the next recession. The faster and earlier they cut rates, the sooner they will exhaust their ability to stimulate. Will they really cut if the economy continues to chug along?
The Powell pivot
The third concern is over the Fed’s credibility. After hiking rates last year and talking strongly about the need to construct policy without considering the financial markets, the sudden perceived dovishness has been termed the Powell pivot. I have written on this shift before, and yesterday’s meeting was another step in this direction. At a minimum, this perceived dovishness revives the notion of a Fed put (now the Powell put). In addition, given the president’s recent public pressure on the Fed, it compromises the Fed’s independence. If we were to get another financial crisis, a less independent Fed might be less able to act credibly in the markets. So, this decision matters beyond the question of inflation.
Maybe not so dovish?
For all these reasons, I suspect the actual intent is not as dovish, nor will rates cuts be as fast, as markets are now expecting. Many of the current worries are headline driven, especially around trade, and could be resolved with an agreement. The willingness to cut rates, if needed (which is what the Fed is saying), is not the same thing as the determination or the need to do so soon.
When you look at the details of the meeting, you see further evidence of this argument. The median interest rate projection was unchanged for this year. Half of all committee members don’t see any rate hikes at all this year. There is certainly movement toward an easier policy, but it is not an unstoppable trend—and could again be changed by incoming data.
Two pieces of the puzzle
There are two pieces to this puzzle: the economy and rates. Right now, I suspect the market is expecting the best of all possible worlds: continued economic growth and lower rates. More likely is that we will get continued growth and flat rates, or slower growth and lower rates. These latter two options aren’t bad, but they are certainly not as positive as the first scenario.
Surprise ahead for markets?
What the Fed has indicated in its statement is that scenarios two and three are the likely options (i.e., continued growth and flat rates, or slower growth and lower rates) but that we won’t get a fourth case (i.e., slower growth and flat rates). Further, it makes no commitment to moving toward the first scenario (i.e., continued economic growth and lower rates).
If we truly have a data-dependent Fed, which is what I took from yesterday, the Fed will act only as needed. And that is not what markets are expecting.