(John Kemp is a Reuters market analyst. The views expressed are his own)
* Chartbook: tmsnrt.rs/2VEKGKl
LONDON, March 7 (Reuters) - The Federal Reserve’s next move on interest rates is more likely to be cutting than raising them – given the late stage in the business cycle and its response in similar circumstances in the past.
Federal Reserve interest rates are set in a judgment-driven discretionary process by the members of the Federal Open Market Committee (FOMC) rather than following strict rules.
Nonetheless, policy-controlled interest rates tend to follow a well-defined cycle as policymakers confronted with similar economic data tend to make similar choices (tmsnrt.rs/2VEKGKl).
In cases where the FOMC has put interest rates on hold after a series of previous rate increases, while it re-evaluates the balance of risks, the next move has normally been to cut them.
The FOMC tends to hit pause when the economic expansion is mature, the yield curve is threatening to invert, inflation appears contained and the economy is expanding at a moderate pace.
By this stage, the principal cyclical indicators, such as the Institute for Supply Management’s manufacturing index have normally peaked and are trending lower.
If the rate of expansion subsequently slows further, or hits a “soft patch”, the committee normally responds by cutting interest rates to sustain growth.
Lack of clear inflationary pressure enables policymakers to prioritise sustaining growth over controlling prices and justifies the interest rate reduction.
In recent decades, it has been rare for policymakers to resume raising interest rates after hitting pause for any length of time.
Short-term interest rates normally peak before the expansion is finished and are already falling by the time the economy enters recession.
Bill Dudley, former president of the Federal Reserve Bank of New York and vice-chairman of the FOMC, and now an opinion-writer for Bloomberg, takes a different view.
“The next move, albeit delayed, will still be up,” he argued in a thoughtful commentary published on Wednesday (“Don’t assume the Fed is done raising rates”, Bloomberg, March 6).
“I expect the U.S. economy to grow faster than usual this year. This probably won’t be evident in the first quarter, because the government shutdown, trade uncertainties and underwhelming tax refunds will dampen growth. After that, the picture is likely to brighten.”
“For the Fed, ‘patient’ doesn’t likely mean finished,” Dudley wrote, and few analysts have more first-hand knowledge of the rate-setting process.
But resuming an interest-rate raising campaign after hitting pause for half a year or more would be relatively unusual.
SOFT PATCH RESPONSE
The current economic picture has similarities with 1997/98, when interest rates were put on hold and then cut by 75 basis points between September and November.
In 1998, the Fed noted domestic growth had slowed and weakness in the rest of the world stemming from the Asian financial crisis threatened to weigh on the U.S. economy.
Fed Chairman Alan Greenspan told the FOMC in September 1998: “The economy has been holding up, but it is now showing clear signs of deterioration, including anecdotal indications of some softening that we now are picking up at an increasing pace.”
“As best I can judge, the indications of weakness are becoming more pervasive but by no means dangerous thus far,” Greenspan observed (transcript of a conference call held on Sept. 21, 1998).
A week later, the committee announced the first of what proved to be three quarter-point interest rate cuts and issued a press statement:
“The recent changes in the global economy and adjustments in U.S. financial markets mean that a slightly lower federal funds rate should now be consistent with keeping inflation low and sustaining economic growth going forward,” (press release from the FOMC held on Sept. 29, 1998).
Following the rate reductions in late 1998, the economy narrowly averted recession and continued expanding through the remainder of 1998-2000, through the dotcom bubble, until it entered recession in April 2001.
After cutting rates by 75 basis points in late 1998, the Fed reversed course, starting to increase them progressively from June 1999 onwards until what proved to be the cyclical peak in June 2000.
Current conditions bear a resemblance to 1998, including the already very low unemployment rate, low inflation rate, near inversion of the yield curve, and the weakness of the global economy.
The global economy and financial markets were under more intense pressure in 1998 and the spill-over to the U.S. economy was more obvious than in 2019.
But the IMF and other forecasters have recently warned the global outlook is “fragile” in 2019 and financial markets show elevated signs of stress about the possibility of a recession.
In these circumstances, it is not hard to imagine a scenario in which the Fed responds to any evidence of further weakening by trimming interest rates in an effort to keep the expansion going.
It is possible the U.S. economy will pull through any temporary soft patch and continued above-trend growth later in 2019 and 2020 will threaten to push up inflation and encourage the Fed to increase interest rates again.
The United States and China might reach a trade agreement, lifting an important source of uncertainty for equity investors and business leaders.
Global trade growth may accelerate again as European and Asian economies pull out of their current sharp slowdown.
U.S. consumers and businesses could remain confident and keep consumption and investment spending growing strongly.
And oil prices may resume their previous upward trend as consumption growth and OPEC production cuts cause the market to tighten, putting upward pressure on global inflation.
In that case, Dudley will be proved right, and the Fed will not be done with raising interest rates in this cycle.
The current expansion, already 117 months old, could pass the record 120 months set during the long boom of 1991-2001, then continue through 2019 and 2020.
On balance, however, many investors are calculating it is more likely the Fed will leave interest rates on hold for an extended period or cut them later in 2019/2020 to keep the expansion going in the face of sluggishness.
- The Yield Curve as a Predictor of U.S. Recessions (Estrella et al/FRBNY, 1996)
- The Yield Curve as a Leading Indicator: Some Practical Issues (Estrella et al/FRBNY, 2006)
- Growing U.S. trade deficit points to suppressed inflation (Reuters, March 6)
- U.S. economy set to slow as fiscal stimulus fades (Reuters, Feb. 22)
- Slowing U.S. economy can ill afford any more shocks (Reuters, Feb. 19)
- U.S. government’s borrowing binge poses global risks (Reuters, Nov. 8) (Editing by David Evans)
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