Boxed-In Fed Facing A Difficult Balancing Act

Boxed-In Fed Facing A Difficult Balancing Act

Given the financial markets' increasing focus on global monetary policy, this week contains some key events for them to digest, with central bank meetings in the US, UK and Japan.

Most market attention will focus on the US Federal Reserve meeting and its projections for the likely path of interest rates.

The last set of rate projections in March showed that the Fed expected to keep rates unchanged this year at 2.375%, before delivering one final 25 basis points increase in 2020.

Markets, though, have become convinced that the Fed will have to cut rates this year.

They are pricing in a rate cut as early as next month and another in the autumn, to be followed by two further cuts in 2020.

There is no doubt that Fed officials have softened their language on rate policy recently on signs that the economy has lost some momentum in the second quarter and amid escalating trade wars involving the US.

Activity in manufacturing and housing has weakened, while global growth has also slowed.

However, consumer confidence remains strong, household spending is showing continued solid growth, while the labour market remains tight with the unemployment rate falling to 3.6%, a near 50-year low.

Inflation, though, is below target and wage growth remains stable and moderate.

Thus, the Fed faces a difficult balancing act and is under increasing political and market pressure to deliver pre-cautionary rate cuts, starting this summer, to ward off the risk of a sharp slowdown in activity.

It would be somewhat ironic if, just after the current US cycle becomes the longest expansion on record this month, the Fed starts to cut rates.

Indeed, there is a risk that if the Fed does not signal, at this week’s meeting, that rates cuts are coming, there could be turmoil in markets that would add to the downside risks for the economy.

Both equity and bond markets have seen strong rallies in the expectation that the Fed will cut rates.

Thus, to some extent the Fed is boxed in. It is likely to proceed cautiously and indicate that it is prepared to cut rates, if necessary, in the coming months.

However, it will anchor any rate cuts as a response to weak data rather than oxygen for markets.

Boxed-In Fed Facing A Difficult Balancing Act

The Bank of England is also in a bit of a dilemma. Recent comments from policymakers show that it retains a tightening bias in the face of a strong labour market and accelerating wage inflation.

Official rates are currently pitched at 0.75%. The Bank of England chief economist wrote recently that "the time is nearing when a small rise in rates would be prudent".

The markets don’t agree, however, with futures contracts pricing in that UK rates will remain unchanged over the next few years.

It is hard to see the Bank of England raising rates anytime soon, given signs that the economy is losing momentum again, and with ongoing Brexit uncertainty set to continue as a headwind over the remainder of this year, against a backdrop of slower global growth.

Thus, despite the recent comments from Bank of England officials, we expect its Monetary Policy Committee will again vote unanimously this week to keep policy on hold and leave rates unchanged.

The same outcome is expected from the Bank of Japan meeting as it sticks with its current negative interest rate policy.

All eyes, then, are on the Fed this week as markets look for rate cut signals in the US.

Oliver Mangan is chief economist at AIB.

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