The Fed’s assumed – but as yet unproven – enthusiasm for cutting rates aggressively in the face of economic slowdown is likely not just due to growth fears. Low inflation expectations are an increasing concern, here and elsewhere.
1. Fed rate cuts will primarily be driven by U.S. economic growth concerns, exacerbated by continuing trade conflicts.
The Fed’s apparent quick flip from gradually raising rates to a rate cut philosophy is due to several factors. Most obviously, there are growing fears about the U.S. growth outlook – in part due to apparently deepening trade conflicts. Hopes of quick resolutions here are fading. Pressures to reverse the 25% tariffs on USD200bn of Chinese imports are not acute (at least for now), the Section 232 auto investigation rumbles on and the threat remains of a new tariff-related eruption remains, in Europe (e.g. Russia/Germany gas pipeline expansion), Mexico (recent “deal” proves inadequate) or elsewhere.
2. But low inflation is increasingly worrying the Fed too: this is not just a problem for the ECB and the Bank of Japan.
Below the surface, there are also growing fears about inflation – or, more precisely, the lack of it. We discuss the U.S. situation on pages 2 and 7. Recent CPI data disappointed and the focus is now turning to the personal consumer expenditure numbers to be published on June 28. Some Fed officials have also expressed their worries about too low inflation – even given apparent labour market strength – and it seems likely that the Fed will want to act sooner-rather-than-later to anchor inflation expectations around the 2% level. The sobering lesson from Japan and the Eurozone is that once inflation expectations collapse, they are difficult to resurrect. As we discuss on page 3, low inflation in Europe is also not a problem that is limited to the Eurozone. A recent Fed policy review conference also considered the argument that it might be worth running inflation above target for a while, to counter the effect of sustained inflation undershooting on expectations. All this may add to pressures to make Fed policy more dovish, more quickly than the growth outlook alone would seem to indicate – although we would stress that market expectations of three Fed rate cuts this year are just expectations – they may be overdone and that there is room for disappointment.
3. Elsewhere, India has already been cutting rates for traditional monetary policy reasons: pressures remain, however.
With inflation levels still low (particularly in Europe), central banks may feel that they have some room for policy loosening. But there are still some dangers around it, not least in encouraging a drug-like dependence by the markets on continued hints of policy easing. This is all rather too reminiscent of during the nadir of the global financial crisis. Continued market volatility seems certain as a solution to current trade tensions takes time to emerge: we therefore stick to our call to take profits and recalibrate portfolios.
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