The Fed is Cutting Rates. Will That Be Enough?

The Fed has now cut its benchmark interest rate by 25 basis points at each of its last two meetings. The market is priced for, and most analysts expect, roughly one additional 25-basis-point rate cut in the next few months. We’re a little more aggressive than that. We think that the Fed is likely to cut rates more than other people seem to expect.

The reason for that is simply that our economic view is a little bit more pessimistic. We’re concerned about the forward-looking outlook. We think that the global slowdown and the accumulated effects of the trade war mean that the economy is likely to slow more than the consensus forecast expects. Now as a result of that we think that the Fed will respond by cutting rates a little bit further than the market expects. We think that that will be effective enough to prevent the economy from falling into a recession. But we have to acknowledge that there are risks there. And if the economy were to worsen more than we anticipate, it’s highly likely that the Fed would have to cut its benchmark interest rate back to zero. We’ve spent a lot of time thinking about, and we expect that the market will spend time thinking about, what other policy tools might be available once the interest rate that the Fed targets is at zero. We think that there are still tools available there and there is some reason for optimism that they might be effective. I’ll point to two specifically. Forward guidance, in which the Fed pledges not to raise interest rates either for a set period of time or until certain macroeconomic benchmarks are hit, is something that the Fed used effectively during the last crisis and it’s something we think they would use again should the economy fall into a more negative situation.

I don’t think there’s any reason to doubt that the Fed would go back to quantitative easing as well, as it did during the last crisis. Quantitative easing, wherein the Fed expands its balance sheet, seems to have gone off and seems to have been effective without causing material risks to the economic outlook. It’s something that they’re comfortable with. And, while it might have been considered unconventional policy before, it’s something that we think of as conventional policy now.

There is an unusual degree of dissension within the Fed at the moment. At their last meeting, while they did vote to cut interest rates by 25 basis points, two members of the committee voted not to cut rates at all and one member voted to cut them by 50 basis points. I think it’s a good thing to see both points of view represented within the Fed, and over time I think that the dissension will sort of take care of itself. If we’re right that the economy does slow, those who have been reluctant to cut rates will come along; and if the economy doesn’t slow, if the labor market stays in solid shape, then the pressure for additional rate cuts will fade as well.

Eric Winograd is a Senior Economist at AB.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.