The Federal Open Market Committee (FOMC) is poised to cut the policy rate at its meeting on July 30–31, but members of the committee are divided. Markets are pricing a 25 basis point (bp) cut, and we believe that is the most likely outcome, but we also see a meaningful chance of a 50 bp cut.
Following the June 18–19 meeting, a majority of the FOMC was still in favor of keeping rates on hold through the end of 2019 (according to the Fed’s economic projections and “dot plot”). However, the tone of Fed communications has taken a somewhat more dovish shift in the weeks since. Of note, Fed Chair Jerome Powell, in his semiannual testimony before Congress last week (and during a dinner speech at the Bank of France on Tuesday), didn’t discuss the prospect of maintaining the current level of the interest rates (i.e., not cutting) – we see this as evidence that he and others on the Fed’s Board of Governors are in favor of easing and were very likely the participants forecasting at least 50 bps in rate cuts by the end of this year.
Why cut? Potential areas of concern in U.S. economy
With U.S. real GDP growth likely to average a solid 2.5% in the first half of 2019, and the unemployment rate sitting at 3.7% – a multi-decade low – various commentators have stated that the economic data don’t justify a rate cut. Furthermore, Powell and other FOMC officials have characterized the U.S. economy as “in a good place.” However, we see several compelling arguments for somewhat more accommodative monetary policy.
- Real growth in goods-producing sectors has decelerated materially. Despite solid overall GDP growth year-to-date, a closer look at the data reveals severely negative growth momentum in U.S. manufacturing, investment, and exports. And according to surveys, business confidence in the outlook has deteriorated.
- Labor market momentum is slowing. While our baseline outlook continues to be for a healthy U.S. consumer to support growth, there is a real risk that the areas of economic weakness spill over into labor markets and consumption more than expected. Payroll growth and (more importantly) aggregate hours worked are slowing as companies cut back hours and slow the pace of hiring in response to weaker sales growth.
- Data are confirming that the real neutral interest rate is lower than some FOMC participants previously thought. Indeed, the U.S. economy appears quite sensitive to rising interest rates. Growth in real investment in structures has slowed as the Fed has raised rates over the last two years. Private construction investment has decelerated, and commercial real estate construction is currently contracting by over 10% year-over-year (source: Commerce Department, Haver Analytics).
- The Fed’s openness to rate cuts has been an important contributor to easier financial conditions, despite higher business uncertainty. Lower interest rates account for much of the easing in financial conditions over the last several months. As a result, if the Fed doesn’t cut rates and bond market yields rise, there is a meaningful risk that ensuing tightening of financial conditions restrains growth.
- Inflationary pressures are modest and financial stability risks manageable.Although the timing of the stronger-than-expected June core CPI print was awkward for the Fed, a broader assessment of the wages and prices data suggests that the inflationary risks of easier monetary policy are modest. Of note, unit labor costs – which adjust wages for productivity gains, and are therefore a better measure of the likely pass-through of higher wage inflation to consumers – have declined for the past two quarters, according to Bureau of Labor Statistics data.
In our view, a 25 bp cut remains the most likely outcome of the July Fed meeting; however, we wouldn’t rule out a 50 bp cut. Recent U.S. economic data have been somewhat more encouraging, but the broader growth trends in a number of sectors still look notably weak. This, coupled with less room for conventional monetary policy easing and the potential costs of a recession (a retrenchment in labor force participation and a contraction in investments that enhance future productivity), argue for easier monetary policy – including a strong case for a 50 bp cut in July – to help insulate the U.S. expansion from negative economic shocks.
Learn the key takeaways from PIMCO’s Secular Outlook for the economy, policy, and markets over the long term.
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.