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September Flashlight for the FOMC Blackout Period

Executive Summary

Coming off the first rate cut in a decade, the Federal Reserve Open Markets Committee (FOMC) heads into its September meeting with financial markets not so much considering whether it will cut rates again, but rather by how much and what it will provide in the way of forward guidance. At a speech in Zurich, Switzerland on September 6, Fed Chairman Jerome Powell did little to disabuse financial markets of the widespread expectation of another rate cut in September. Chair Powell enjoys having the last word, as we have now entered the blackout period, the time in the lead-up to the FOMC meeting during which Fed officials refrain from commenting on monetary policy.

In our view, the most likely outcome for next week’s meeting is that the FOMC will cut the fed funds rate another 25 bps, while continuing to emphasize risks to the outlook from global growth and trade policy and acknowledging that inflation remains below target. All told, the meeting should keep the door open for additional easing over the next few months. As we did in our Flashlight publication in July, we handicap various potential outcomes for the September 18 FOMC meeting in this report.

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The Days Are Getting Shorter and Darker Since July

With less room to cut rates in this cycle than it has had in the past—the Fed would have 225 bps of “ammunition” if it took rates all the way back to 0%—the Fed must be judicious even to the point of sparring about each rate cut in this cycle (Figure 1). Overall, the labor market remains tight, as evidenced by the unemployment rate remaining near multi-decade lows. Inflation has picked up recently, with the core PCE deflator up at a 2.2% annualized clip over the past three months (Figure 2). However, strictly speaking, at 1.6% year-over-year, the core PCE deflator remains below the Fed’s 2% target, so the FOMC has cover to ease on that basis alone.

But there are a number of factors affecting the economic outlook that could threaten the Fed’s dual mandate (full employment and stable prices) in the future. For starters, the marked slowdown in U.S. export growth in recent quarters, due to Chinese tariff retaliation and generalized deceleration in global economic activity, could remain a headwind to U.S. economic growth. Trade policy uncertainty is also putting business plans on hold and leading to outright declines in manufacturing. This is most prominent in the ISM manufacturing index, which slipped into contraction territory in August for the first time since 2016.

U.S. households remain in good shape with low debt service, a high saving rate and spending on track for another solid outturn in Q3. But there are signs the trade war is beginning to weigh on consumer sentiment as well. One in three consumers surveyed by the University of Michigan spontaneously mentioned the trade war and tariffs in August as that measure of consumer sentiment fell to its lowest since just before the 2016 election.

With low inflation as a workable justification and with trade-related risks having intensified over the past month and a half, another rate cut in September looks like all but a done deal at this point. Markets are currently pricing in a 100% probability that the FOMC will reduce the fed funds rate next week. For all these reasons, it is arguably less important what the Fed does in September and more important what it will offer in terms of forward guidance, which is our focus in the various scenarios we consider in this report.

Scenario 1: Straight Down the Fairway

  • Fed funds rate: 25 bps cut
  • Language: Dovish–Downside risks from trade have increased; maintains pledge to sustain the expansion
  • Dots: A sizeable number of dots shift down to 1.63% at end of 2019
  • Probability: 60%

The most likely outcome of the FOMC’s upcoming meeting in our view will be another 25 bps cut, with a sizeable number of committee members keeping the door open to further easing. Little has changed in the economic environment, which makes this reprise of the July meeting our base case. Growth still looks to be moderating slightly, with consumer spending solid but investment weakening. Inflation also remains disappointingly low; the core PCE deflator is up 1.6% year-over-year and inflation expectations hover near historic lows.

More significantly, the risks to the U.S. economy from slowing global growth and trade policy have intensified since the last Fed meeting. Although trade talks look to be back on track beginning in October, the direct costs of the trade war are set to nearly double after August’s events, and with it related uncertainty (Figures 3 and 4).

In this scenario, not only will the FOMC cut rates, but it will maintain its pledge “to act as appropriate to sustain the expansion.” In addition, a sizeable number of dots will shift down to 1.63% at the end of 2019. In the last Summary of Economic Projections (SEP), released at the conclusion of the June 19 FOMC meeting, 7 of the 17 FOMC members saw the fed funds rate ending the year at 1.88%. There were no dots below 1.88%. If, as we expect, the FOMC delivers another 25 bps rate cut on September 18, t