Monetary Policy Analysis > Considerations Factoring Into a Precautionary Cut
Date: June 17, 2019
From: Bill Nelson
Subject: Considerations Factoring into a Precautionary Cut
The FOMC appears to be considering a cut in its target range for the federal funds rate to address downside risks to the growth outlook and the persistent undershoot of inflation from the FOMC’s 2 percent target. In weighing such a cut, there is a lot to take into account.
- When cutting in response to downside risks, you want your policy action to increase, not decrease, confidence.
- Because of the proximity of the zero lower bound, cuts should be more aggressive than otherwise.
- When easing, the FOMC measures the success of its action by the size of the market impact; that is, it welcomes a surprise.
- An increase in downside risks and an undershoot of inflation calls for a reduction in the target rate, but not a series of reductions unless the situation worsens.
- The market responds poorly to any indication that the FOMC is on the sidelines (as was again made clear at the end of last year.)
Putting all this together, if the FOMC cuts, I agree with Mike Gapen (Chief U.S. Economist at Barclays) that it will cut big. A big cut would be more likely to boost confidence, would provide the stimulus needed to push up inflation and keep away from the ZLB, and the cut would have to exceed expectations for there to be a positive market response. Moreover, the situation calls for a realignment of rates to a position where the Committee would feel comfortable staying as it awaits more information.
At the same time, if the Committee announced that it was going to hold at the lower level for a while, the market would react negatively, so the cut would be coupled with an indication of vigilance and a willingness to do more if necessary. The FOMC could even couple the cut with an indication that it would not raise rates at least until average inflation rose above 2 percent. Such inflation-only threshold-based forward guidance that Seth Carpenter, Chief U.S. Economist at UBS, first suggested, would fit well into the current average-inflation-targeting zeitgeist.
None of this seems likely at the upcoming meeting. With the funds rate still on the soft side of neutral and the unemployment rate well south of the NAIRU, the Committee will want as much information as possible before moving including learning what happens at the G20 meeting.
In fact, I would guess the June statement will be changed as little as possible. Building expectations for a July cut further would not only put the FOMC in a position that would be hard to walk back from, more modest expectations for July are easier to exceed.
A word on the dots: The Board and Presidents do not choose the dots strategically. Moreover, they often simply write down the fed funds rate that come out of the staff forecast of the Board or (for the Presidents) their Reserve Bank. The forecasts are of the mode (the most likely outcome) of the economy, and so are not particularly influenced by changes in risk. Bottom line, the dots might not change much.
Happy as always to discuss, feel free to share, and let me know if you’d like to stop receiving these emails.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.