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New math: Federal Reserve will lower rates this week, but future cuts are no sure thing

“If Saudi Arabia and Iran escalate the conflict, the more we’ll see higher inflation and slower growth. That’s not a good combination for the Fed,” said one financial analyst.
Image: The Federal Reserve in Washington in 2017.
The Federal Reserve in Washington in 2017.Kevin Lamarque / Reuters file

Although the Federal Reserve has all but committed to cutting interest rates at its meeting this week, expectations for more accommodative monetary policy have undergone a sharp reversal over the past month. Mixed economic signals are making it hard even for the experts to get an accurate read on the nation’s economic health.

While there is broad consensus that Fed Chairman Jerome Powell will announce a quarter-percentage-point rate cut on Wednesday, future visibility is considerably murkier. Some analysts argue that the Fed should — and must — stop lowering rates, while others say fragility in business confidence and weakness in the manufacturing sector compel the central bank to play a more supportive role.

“There are two main categories of factors that would make the Fed less dovish. One is improved economic fundamentals… basically, employment and inflation continue to be pretty strong,” said Putri Pascualy, managing director for PAAMCO Prisma, while global trade tensions have eased, she added. “The Fed has less reason to cut rates because these extreme risks have been pushed further out.”

But other data tempers that glass-half-full outlook. “Their interpretation of the economy from the consumer perspective and the manufacturing perspective [is that] one’s doing well and the other one seems to be under a little pressure from the trade war,” said Matthew Kennedy, managing director and head of corporate credit at Angel Oak Capital Advisors. “The household balance sheet seems to be pretty solid. I think the real concern for them comes down to the impact of the trade war.”

Another wild card is this week’s oil price shock following the weekend attack on key Saudi Arabian production facilities. Analysts say a sustained interruption that constrains global oil supplies and drives up prices could propel inflation higher.

“The price action in oil is very hard to estimate the impact on the economy, because we don’t know how long it’s going to last,” said Zhiwei Ren, managing director and portfolio manager at Penn Mutual Asset Management. “If Saudi Arabia and Iran escalate the conflict, the more we’ll see higher inflation and slower growth. That’s not a good combination for the Fed,” he pointed out, because this dynamic can tip into stagflation.

The end result of trying to interpret this wave of incoming data is a divergence, which analysts said they expect to see reflected in the “dot plot” indicating policymakers’ outlooks. “We expect to see greater dispersion of the dots,” said Lindsey Piegza, chief economist at Stifel Fixed Income. “I think you’re seeing these two fundamental views of the economy pulling away from each other.”

Even this week’s potential cut, while still widely anticipated, is not seen as the foregone conclusion it was only a few weeks ago. On Tuesday, the CME’s FedWatch tracking tool showed a 66 percent probability of a 0.25 percent — or 25 basis points — cut, with a 34 percent expectation of no cut. Exactly a month ago, the ratio was a near-complete reversal, with a 78 percent expectation of a quarter-point cut and a 22 percent probability of a half-point cut. The probability that the Fed would maintain interest rates at their current level: 0 percent.

Expectations of future cuts have been tempered, as well. “From now until year-end, the probability of us getting three rate cuts has been going down,” Pascualy said.

Jamie Cox, managing partner at Harris Financial Group, suggested that this week’s cut is driven more by investor expectations than current conditions — essentially, that Powell’s hand is forced by the desire to avoid a market meltdown. “The Federal Reserve has signaled to the market that they’re going to go 25 basis points, and the Fed does not like to surprise markets,” he said, although he predicted that the Fed Chairman will make it clear in his accompanying remarks that the central bank doesn’t plan to be locked into future cuts. “I think we’re getting to the end of the line for rate cuts,” Cox said.