Markets doubt Fed’s ability to defend economy, spur inflation
From the market’s point of view, neither prospect is looking great. Market conditions have grown harsher and data is pointing to lower inflation.
Fed policymakers, economists and other officials are convening at an annual monetary policy retreat in Jackson Hole, Wyoming, this week, a bucolic backdrop for a tough discussion about whether central bankers can hold off the next recession.
Interest rate cuts can take months to spur growth. Still, policymakers’ verbal commitment to sustain the longest U.S. economic expansion on record, backed up by the recent rate cut, probably made it a bit cheaper for businesses and consumers to borrow this year.
The average rate on a 30-year mortgage is now just 3.90%, according to the Mortgage Bankers Association, after hitting north of 5% late last year, and U.S. banks broadly lowered their so-called prime rates after the Fed cut its overnight benchmark lending rate on July 31.
What remains unclear is whether Fed rate cuts alone can calm markets’ recession fears, which have ramped up amid a recent escalation of the U.S.-China trade war, and convince enough investors that their elusive inflation goal is achievable.
“There’s an unspoken realization of at least most market participants that whatever rate cuts the Fed decides on – or even if the Fed decides to embark on QE – it’s not going to be an adequate countervailing force to tariffs,” said Kristina Hooper, chief global market strategist at Invesco. QE, or quantitative easing, refers to the Fed buying bonds to support the economy as it did after the 2008 global financial crisis.
On Wednesday, Minneapolis Fed President Neel Kashkari called for even more action now, writing in an op-ed for the that the Fed should both cut rates and commit not to raise them again until the economy hits its 2% annual inflation target for a sustained period of time.
Since the rate cut last month, markets have been on the fritz, under pressure from the U.S.-China trade tensions and signs of a global slowdown. That has worsened a host of market indicators, from stock to corporate bond prices, that influence economic growth.
Fed Chair Jerome Powell’s unwillingness to commit to more easing at his press conference following the rate cut on July 31 was not a primary cause of the market swings, but it did not help matters either, investors said.
Policymakers had wanted to soothe markets, making it easier to borrow and giving people more reason to spend. Yet Goldman Sachs’ measure of financial conditions is now tighter than before the July rate cut, though the index has eased over the course of the year as central bankers effectively committed to not raising rates any more.
“My biggest concern is the efficacy of cuts or lower rates,” said Jason Brady, chief executive officer of Thornburg Investment Management. “The Fed has a very variable economic backdrop, which is less supportive of 2% inflation or a whole lot of real growth.”
The Fed also hopes a rate cut will help it hit the 2% inflation target that is has been undershooting. At their recent policy meetings, some Fed officials have fretted that people might be starting to think that inflation is falling, which in theory could cause prices to stall.
Weak inflation could hold back wage growth and spending and also force interest rates down to zero. That would leave officials with few tools to encourage more growth and restore the economy during the next downturn.
Philadelphia Fed President Patrick Harker told reporters earlier this year that if inflation goes below 2% “for a long time and keeps drifting down, most likely expectations are going to drift down too.” But he said the exact relationship between those expectations and future inflation is not fully understood. “There are lots of different theories. We don’t really know.”
There are signs in official data that inflation may be perking up and that some of the recent misses have been based on temporary factors.
Still, investors are not viewing the Fed’s inflation-boosting efforts as particularly credible.
The inflation level expected over a five-year period starting in 2024 sank to a two-year low of 1.71% after the Fed’s recent rate cut, according to a closely watched gauge based on market prices.
Risk-averse investors bought so many 30-year Treasury bonds in recent days that they pushed yields to a record low of 1.916%, which translates to a high price for an inflation-sensitive bond that could shed value if dollars keep losing purchasing power.
“What the market is pricing in for future inflation expectation is simply too low,” said Leslie Falconio, a senior strategist at UBS Global Wealth Management. “You’ll see a greater shift in a rise in inflation due to tariffs and due to more Fed easing taking place.”
Clearly not everyone is convinced. Adam Posen, a former Bank of England policymaker and the current president of the Peterson Institute for International Economics, said policymakers have failed to spur inflation and may be too focused on trying to get investors and other people to lift inflation expectations in a world where other pressures could be keeping prices in check.
“Inflation targeting is just too obsessed with this expectations-driven view,” Posen said.
Still, years of moderate inflation may be taking hold in how people see the economy. Bond markets’ diminished growth and inflation outlooks are even more striking given their high expectations for the Fed to act. Investors are pricing in cuts at each of the rate-setting Federal Open Market Committee’s (FOMC) three remaining meetings this year, according to CME Group’s FedWatch Tool.
“There is market confidence the FOMC will continue to lower rates and provide monetary policy accommodation, but there is no conviction that this will lead to actual inflationary pressure,” analysts at BMO Capital Markets said in a recent research note.