HIGHLIGHTS OF THE WEEK
- The biggest event this week was the Fed’s pivot away from patience. It is now poised to act in the event of a further deterioration in the outlook. This cheered markets, with stocks and bonds rallying.
- The Fed’s dot plot also showed that the majority of FOMC members judge the funds rate to already be at its long-run neutral level, and expect to lower rates next year.This is a seismic shift from expecting hikes back in December.
- Our new forecast released this week, calls for the Fed to cut rates twice this year, as insurance against the downside risks that have accumulated due to trade tensions, and a late-cycle economic slowdown.
The Powell Pivot
For the second time in the past six months, the Federal Reserve has pivoted on where it thinks interest rates are headed over the next few years. Back in December, the median projection of FOMC members was for 175 basis points of rate hikes by the end of 2020. Now, it is a 25 basis point cut. That is quite the pivot (Chart 1). In its statement the Fed has also shifted from patience to action. The FOMC will now “closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion”.
At the same time, the Fed’s expectations for economic growth have shifted a lot less. The median FOMC forecast for growth is 2.1% this year and 2.0% next year, down only slightly from 2.3% and 2.0% back in December. Looking only at growth expectations it is hard to justify the pivot in interest rates. However, the updated growth forecasts incorporate a lower path of interest rates. Previously, the FOMC believed the economy would grow at that pace as it continued to raise rates. Now it expects that a cut will be required to sustain that near-trend pace.
A big part of the pivot is the continued miss on its inflation forecast. In December, the FOMC expected inflation to be back at 2% by the end of this year, and now that isn’t looking too likely. Given the difficulty sustaining the 2% inflation target, it has lowered its estimate of the “neutral” rate to 2.5%. That is the level at which the rate neither stimulates, nor stifles economic growth. Clearly the Fed has come around to the view that rates over the past little while have been less stimulative than they previously believed.
A majority of FOMC members now believe that at least one rate cut will be required to keep inflation at target and promote maximum employment, and seven out of 17 members judge that it will need two quarter-point rate cuts.
The Fed is paying close attention to signs that the economy is slowing. Both the Philly and Empire Fed manufacturing sentiment indicators released this week showed that sentiment soured in June. Now, those readings may have been taken at the time that the President had threatened tariffs on Mexico, before pulling back at the eleventh hour. But, other manufacturing sentiment indicators globally have cooled, supporting the Fed’s vigilance on downside risks.
Our recent forecast (Chart 2) lowered our fed funds rate call for this year, adding in two insurance cuts (see report). We expect cuts are needed to keep growth on track, as persistent trade uncertainty weighs on business sentiment and investment. The upside to rate cuts is that they should provide a bit of fuel for the housing market, which has been largely moving sideways over the past year. Housing data for May showed that while construction activity remains lackluster, the resale market increased 2.5% on the month. That suggests the drop in mortgage rates over the past six months may finally be lifting activity. And a more modest path for rates ahead will help improve affordability.
Leslie Preston, Senior Economist | 416-983-7053
This report is provided by TD Economics. It is for informational and educational purposes only as of the date of writing, and may not be appropriate for other purposes. The views and opinions expressed may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The report does not provide material information about the business and affairs of TD Bank Group and the members of TD Economics are not spokespersons for TD Bank Group with respect to its business and affairs. The information contained in this report has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. This report contains economic analysis and views, including about future economic and financial markets performance. These are based on certain assumptions and other factors, and are subject to inherent risks and uncertainties. The actual outcome may be materially different. The Toronto-Dominion Bank and its affiliates and related entities that comprise the TD Bank Group are not liable for any errors or omissions in the information, analysis or views contained in this report, or for any loss or damage suffered.