Fed’s big rate cut not really all that dovish

Recession, ultra-low rates ruled out

I find myself ambivalent when assessing last month’s Federal Open Market Committee meeting. I disagree with the Federal Reserve’s (Fed’s) choice of a larger 50 basis points (bps) instead of a more moderate 25 bps, but I agree with most of the underlying assessment of the economy that Fed Chairman Jerome Powell laid out. The latter, I believe, is going to prove key to what lies ahead for policy rates and market moves.

Prior to the meeting, those advocating for a 50-bp cut brought two arguments: First, that at 5.25%-5.50%, the policy rate was far above its equilibrium level. Second, signs of a weakening economy – in particular the rising unemployment rate – called for the Fed to take meaningful steps to avert a recession. Both arguments were flawed, in my view, which is why I would have preferred a more prudent 25-bp cut.

Fed dispels recession worries

Given the decision to cut by 50 bps, Powell’s top concern in the press conference was to dispel the idea that the Fed was seriously concerned about a possible recession. He repeated over and over again that the U.S. economy is strong and that the labor market is still at or even above full employment. He said the Fed now sees risks to inflation and employment as balanced but added that he does not see any signs that currently flag a risk of recession.

I could not agree more. Let’s start with the labor market. Yes, the unemployment rate has risen to 4.2% this August from a low of 3.4% in April last year. But that 3.4% was the lowest rate we had seen in about 60 years. Between 1990 and 2007 (the eve of the global financial crisis [GFC]), the unemployment rate averaged 5.4%, and the natural unemployment rate today probably sits somewhere in the 4.5%-5.0% range. So the labor market is just gradually getting back into balance from overly tight conditions. Responding to a question, Powell gave a detailed and data-rich assessment of what he also sees as a very solid labor market. The newly released Summary of Economic Projections (SEP) shows the Fed expects the unemployment rate to stabilize around current levels for the next three years.

Other recent economic indicators also look very healthy; retail sales remained resilient and industrial production rebounded strongly in August, leading the Atlanta Fed to raise its estimate of third-quarter growth to 3% annualized. This is hardly an economy crying out for monetary stimulus. Powell’s assessment? “The economy is in strong shape, and we want to keep it there.”

Although Powell did not mention it, I would add that persistently loose fiscal policy will also give continued support to the economy over the coming years – something I have highlighted several times before. Both presidential candidates have put forward proposals that would lead to a significant increase in the fiscal deficit going forward.

Powell also acknowledged that inflation is not at target yet, though it’s come a lot closer, and the Fed now has much greater confidence that price growth will continue to decelerate to 2%.

Coming into the press conference, Powell also knew that a 50-bp cut might supercharge market expectations of further monetary easing. He poured buckets of cold water on the market’s enthusiasm, stressing that “I don’t think anyone should look at this [50-bp rate cut] and say this is the new pace [of monetary easing].” He stressed that the Fed is now looking at a gradual normalization of rates, and he pointed to the “dots,” where the median implies another two cuts by 25 bps this year (in line with my expectations and bringing the end-2024 fed funds to 4.4%) and an additional 100 bps in cuts over the course of 2025 (to 3.4%).

This brings me to the second crucial issue: How far are we really from the neutral fed funds rate?

How far to neutral?

Taking a simple measure of the real fed funds rate, defined as the nominal fed funds minus the current inflation rate (which is now not too far from the future expected inflation rate) shows that monetary policy is tight, but not exceptionally so, from a historical perspective.

In fact, what jumps out from the chart is not how high the real policy rate is now, but how abnormally low it’s been since after the GFC. I have been arguing for some time that the period between the GFC and the Covid-19 pandemic was a historical aberration, and that a better reference point for where real fed funds should be is the long-term average prior to the GFC. That suggests a real policy rate close to 2%, not that far from current levels.

A quick look at financial conditions also confirms that monetary policy is not that tight (even prior to the September rate cut): (i) equity markets are close to all-time highs; (ii) credit remains abundant; and (iii) spreads on risky assets, from loans to high-yield credits, are tight. The last point, incidentally, also tells me that financial markets are not actually worried about a possible recession – the pricing of risky assets is simply inconsistent with an outlook of shrinking activity and rising bankruptcies.

In the press conference, for the first time that I can remember, Powell cautioned that his “sense” is that we are not going back to the ultra-low interest rates of 2008-2022, because the neutral rate is now significantly higher than it was back then.

Where is the neutral rate now? Taking the near-2% pre-GFC long-term average of the real policy rate I mentioned above, I estimate that, at the end of this easing cycle, fed funds should settle at a neutral rate of 3.75%-4.0%. The Fed (based on the median dot) currently envisions lowering the policy rate to 3.4% by the end of next year, and to about 3% at the end of the easing cycle. I would note that the Fed’s estimate of the neutral rate has been gradually inching up over the past year or so – probably acknowledging the economy’s resilience to the rate hikes – and might well rise further. By contrast, markets expect the fed funds rate to fall to 2.75% already by the end of next year.

A large, non-dovish cut

On balance therefore, Powell managed to deliver a 50-bp cut that was not particularly dovish. I can live with that. Markets, however, were a little disappointed, with 10-year U.S. Treasuries selling off in the immediate aftermath of the press conference, when usually they have tended to rally as Powell’s press conferences often conveyed a dovish signal.

That means that for the Fed, the hard part lies ahead. Past experience suggests that financial markets will keep pushing for more easing than the Fed plans to deliver, especially as a number of investors still expect rates to revert to the extremely low post-GFC levels. Powell has his job cut out for him. The Fed has regained an important measure of anti-inflation credibility, but the “Fed put” enjoys a long-standing track record with investors. I expect we will see several rounds of markets getting overexcited in response to any weakness in economic data, increasing the potential for subsequent disappointments, as we converge in fits and starts back to the pre-GFC norms.

Sonal Desai, Ph.D. is the executive vice president and Chief Investment Officer for Franklin Templeton Fixed Income at Franklin Templeton. Originally published in the Franklin Templeton Insights page.

Disclaimer

What are the risks? All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.

Important legal information. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

Image: iStock.com/Manojkumar Madhusoodananpillai