My sense is that Jerome Powell, Chairman of the U.S. Federal Reserve, is more concerned about global financial conditions, namely weak global PMIs, low global inflation, and weakening growth everywhere, than he is pacified by a strong U.S. labor market.
The Fed detailed the idea of incorporating global factors into their policy reaction function in a June 2019 paper entitled: Monetary Policy & Financial Conditions: A Cross Country Study.1 Here they introduce an ‘augmented' Taylor Rule2 that adds the notion of GDP-at-Risk by incorporating financial conditions alongside the already familiar inflation and full employment variables. I see this as an important development; this deserves more attention than the market is currently paying towards it because it explains the Fed's policy reaction function today.
The market is currently pricing a 25 basis point (bps) interest rate cut by the Fed in July. However, I think a higher probability should be assigned to a 50 bps rate cut.
The Fed's thinking may be as follows: they need to cut rates by at least 50 bps this year, so why wait? They can cut rates by 50 bps in July and then still have the flexibility to cut another 25 bps later in the year if needed.
Furthermore, if the Fed is thinking along the lines of risk management, they may be more inclined toward a 50 bps cut. If there is in fact evidence of a more substantial weakening of U.S. and global growth, then a 25 bps cut is less effective versus a 50 bps cut, as the later would give the Fed extra "insurance" against a declining market. The Fed could then opt not to cut further if economic activity picks up.
I realize my view goes against the market consensus, but in order to better understand the Fed's reaction function we need to appreciate that it is increasingly evaluating financial conditions both in the U.S. and around the globe.
If you evaluate their actions through that lens, then a 50 bps cut doesn't seem so unreasonable, or unlikely; perhaps Chairman Powell wants to keep this ("put") option open. In conclusion, Powell may not push back on a 50 bps rate cut as much as the market was thinking.
Jim Caron, head of Global Macro Strategies on the Global Fixed Income team at Morgan Stanley Investment Management
