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FOMC Preview

There is a growing echo of the possibility of a rate cut this year as the Fed, the US central bank, approaches its scheduled FOMC meeting tomorrow. While markets have been factoring in as many as 3 cuts this year, we do not believe that Fed considers current economic conditions justifying such an extreme move.

Markets were taken aback with surprise after 4 Jun comments from Jerome Powell, Chair of the Federal Reserve, during a Chicago Fed conference. Specifically, he had acknowledged the developments in trade negotiations and admitted, “We do not know how or when these issues will be resolved. We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective.”

Though Powell did not specifically said that the Fed was ready to cut rates, his comments were regarded as the Fed’s acknowledgement to economic risks arising from trade tensions and its readiness to act and reduce rates, if needed.

We do not believe that FOMC, the rate setting committee of the Fed, has enough data points and hence the confidence that economic conditions are deteriorating enough to warrant an immediate change in interest rates. We touched upon the current economic conditions as reflected by the US retail sales in a previous article.Therefore, a rate cut in this meeting is unlikely.

However, market will definitely watch out for any signals for a potential cut in July. This is important as Federal Fund futures, the best gauge of market’s expectations of a rate decision by the FOMC, are pricing in a very high probability of a rate cut as early as Jul. Any indication of a rate cut, change of stance or assessment of economic conditions as “deteriorating” in the FOMC statement itself might be considered expectedly dovish. No such indication and a mere re-iteration – during the press conference – of the comments made on 4 Jun might take away all expectations of a rate cut in July. This could be significantly hawkish and could cause Fed Fund futures to get rid of a good portion of the gains seen recently.

What happened at the beginning of the last rate cut cycle? Is there a similarity?

We went back and checked what happened during the last rate cut cycle that started in Aug-Sep 2007. The first action had come in the form of an inter-meeting cut in discount rates during Aug 2007. The 2nd action was in the form of a cut in Fed Funds rate during the Sep 2007 meeting.

For the first action during Aug 2007, the official statement of the FOMCindicated that the action was taken “to promote the restoration of orderly conditions in financial markets” and to keep it intact “until the Federal Reserve determines that market liquidity has improved materially.” The cut in the discount rate was clearly due to tightening financial conditions triggered by the blow out of the two hedge funds of Bear Stearns.

For the 2nd action in the Sep 2007 meeting, the official statement of the FOMC stated that the action was taken as “economic growth was moderate during the first half of the year” and justified the size of the cut (it was a 50 basis points cut and not the regular 25 basis points cut) indicating that “the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth.” Even before Sep 2007 meeting, Fed had started acknowledging the moderate pace of economic growth.

Contrast that with the recent FOMC statement during Apr/ May meeting that considered economic activity to be rising “at a solid rate” amid “muted inflation pressures”; and continued to view “sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes.” There is no sign of moderate economic activity here.

Therefore, we believe Fed will start giving indications of its assessment if it really considers that economic activity has moderated much before it takes an action. Such assessment doesn’t necessarily has to be communicated through FOCM statement or during a press-conference after the FOMC meeting; it might be communicated through inter-meeting speeches.

Overall, we believe that the Fed will acknowledge risks to economic activity from the escalating and yet unresolved trade tensions and iterate its “patient but ready” stance. This should be good enough for financial markets to fend off the early chatter of rate cuts.

Background Information

The Federal Reserve System or the Fed is the central banking system of the USA. It consists of 12 Federal Reserve Banks throughout the US also known as the 12 district Feds. The System is governed by the Federal Reserve Board of Governors.

The Federal Reserve Board of Governors has seven members and oversees the 12 district Feds including the chair of the board which also acts as the chair of the Fed and the chair of the FOMC.

FOMC i.e. Federal Open Market Committee is a committee of the Federal Reserve System of the US. It sets the monetary policy and oversees the open market operations of the US. FOMC comprises of all of the 7 members of the Federal Reserve Board, the President of the New York Fed, and 4 of the other 11 district Fed presidents.

By law, FOMC is required to meet at least 4 times a year. In practice, FOMC meets 8 times every year to assess the economic conditions and votes on the monetary policy decisions. After the meeting concludes, FOMC publishes an official statement and, in several meetings, holds a press conference.


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