Playing poker well is about understanding two key things: (1) the hand that you’ve been dealt and (2) what that means for the probability of future outcomes. In our view, the hand the Federal Reserve has been dealt (the current economic environment as defined by inflation, labor markets, growth, financial markets, and international conditions) and the probable outcomes it implies for the economy suggest that rate cuts in 2019 will be the most prudent response.
Inflation, as measured by core PCE (personal consumption expenditures, the Fed’s preferred metric) reached 2% last year for the first time since 2012 before falling back below that threshold in recent months. That backsliding caused markets to begin pricing in the possibility of an inflation-stoking rate cut this year. While we continue to believe that inflation will pick up over the rest of the year and fall just a bit short of 2%, other factors have contributed to the evolution of our policy rate expectations.1
The other half of the Fed’s dual mandate is the labor market, which has evolved much as we expected in our 2019 economic and market outlook. The average monthly change in payrolls has fallen close to 150,000 jobs per month. We—and the Fed—would expect this number to continue falling closer to the level of job growth that would account for new entrants into the labor force (80,000–100,000).
On the growth front, the potential for recent trade tensions to hurt the U.S. economy has only strengthened the market’s conviction that rate cuts are appropriate. In response, bond traders, for the second time this year, have pushed long-term yields below short-term yields. This phenomenon, known as an inverted yield curve, is a traditional bellwether for recession.
The figure below shows short-term interest rate expectations from the market, the Fed, and Vanguard. We expect an update to the Fed’s outlook at the close of its June 18–19 meeting.
The market is anticipating one or more “insurance cuts” this year
Sources: Bloomberg, Federal Reserve Bank of New York, and Vanguard.
Note: The Fed expectation is based on the March Summary of Economic Projections; the market assumption is based on the forward rate curve as of June 10, 2019.
The Fed promised patience at its April 30–May 1 meeting
The Federal Open Market Committee said (nine times) in the minutes of its last meeting that it would be “patient” in making any adjustments to monetary policy. Reading between the lines, however, it seemed that the Fed’s pledge of patience might well be applied asymmetrically. Policymakers minimized the likelihood of a rate hike even if data on the labor market, economic growth, or inflation were to strengthen. But they didn’t rule out cutting rates if the data were to weaken. Subsequent communications confirmed this stance, particularly those of Fed Chairman Jerome Powell, who said the Fed stood ready to take “appropriate [action] to sustain the expansion” in light of trade tensions.
Of course, the future is unpredictable. But just as poker players constantly assess and reassess the probability of the outcome of a hand, one can frame the future in the probability of possible outcomes. Given the hand of persistently weak inflation readings, an uncertain trade and growth environment, and an inverted yield curve that the Fed has been dealt, it is becoming increasingly difficult for it to withstand near-term pressures for a rate cut. The Fed isn’t folding, but it’s hoping to better its hand with a few insurance cuts.
1 We had expected two rate increases in 2019, then revised that to no rate increases in March and, more recently, to two rate cuts.
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