August’s employment report, which was weaker than markets were expecting but stronger than our call, cements our view that the easing cycle will begin during the next Federal Open Market Committee Meeting (FOMC).
We know that markets are still pricing in a 50 basis points reduction in the federal funds rate, but we make the case for a 25 basis point reduction below.
But going back to the employment numbers, we believe that markets were being overly optimistic in expecting jobs in August to have increased by 165,000 (Bloomberg expectations), versus our call for a 120,000 increase and an actual number of 142,000, which is probably going to be revised downward and approach our call in the months to come. Thus, we don’t think that a mistake by markets expecting such a strong number versus the actual should be a reason for the Federal Reserve (Fed) to cut 50 basis points during the FOMC meeting.
Furthermore, the rate of unemployment was slightly (very slightly!) lower in August, at 4.221% compared to a July rate of 4.253%, and that is, today, more important for the Fed than the employment number, as it is going to continue to argue that the “rate of unemployment is higher today compared to a year ago” but it is still low compared to history.
Federal Reserve: Beware of Animal Spirits
The Fed has a very difficult decision ahead, with economists, analysts, and markets predicting between 25 basis points to 50 basis points reductions during the September FOMC meeting. Furthermore, we have seen predictions of, at most, 125 basis points cuts for the federal funds rate before the end of this year. This seems to be over the top, but we could construct potential scenarios where this may be required.
For now, the Fed has a roadmap in place that it can use to start its easing cycle: the June dot plot. In that dot plot Fed members’ views on the federal funds rate indicated one, 25 basis point cut, before the end of this year. We agree that this dot plot is out of date and that the dot plot scheduled to be released after the next FOMC meeting will show a very different roadmap for the federal funds rate. But the Fed knows that it has two more meetings before the end of the year and there will be plenty of opportunity for it to lower the federal funds rate during those two meeting according to “incoming data.”
We (and the markets) are concerned that the Fed may be behind the curve as we have said in the past. However, bygones-are-bygones and there is no use in looking back. The most important thing is doing what is right for the economy today. And we still believe that a 25 basis points cut to start the cycle is the safest path for the Fed today.
The reason for our belief is that, typically, the Fed’s changes to short-term interest rates affect longer-term rates and thus mortgage rates. Mortgage rates normally follow the yield on the 10-year Treasury, and that rate has already moved down ahead of the Fed’s move. Thus, for now, the only thing the Fed needs to do is to acknowledge the market’s move.
But a 50 basis points reduction in the federal funds rate during the next meeting, without a previously released dot plot and Summary of Economic Projections (SEP) with its forecast for the US economy could send the wrong signal.
The most important thing to remember is that, at this junction, the Fed continues to be concerned with the economic tailwinds still being provided by fiscal policy while at the same time it doesn’t want to spook the ‘animal spirits’ into concluding that the economy is in trouble because that would have the potential to become a self-fulfilled prophesy.
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