The Fed got as dovish as it could get today without actually cutting short-term rates. 

The Fed's next meeting is at the end of July.  If by that time the Trump Administration has made noticeable progress on a trade deal with China (without backsliding on other trade relationships) and inflation has picked up relative to the Fed's expectations, then a rate cut might not happen; otherwise a rate cut is more likely than not in July. 

Right now, the futures market in federal funds puts a stunning 100% likelihood on a July rate cut.  We think that's too high, but a 70% likelihood seems about right.  The reason a rate cut is now more likely than not is that the Fed is focused on bringing its preferred measure of inflation – the deflator for personal consumption expenditures (PCE) – back up to an average of 2.0% versus the current level of 1.5%.

The Fed made an important change to its economic forecast.  It's now projecting a 1.5% increase in PCE prices this year versus 1.8% back in March.  PCE prices are expected to grow 1.9% in 2020 versus a March forecast of 2.0%.  Notably, it's not showing any year with inflation above 2.0%. 

The reason that's significant is that the Fed describes its 2.0% inflation goal as "symmetric," which means it wants to see an average pace of 2.0% inflation over time, with periods of inflation below 2.0% (like we're in now) offset by periods when inflation runs above 2.0%.  The goal of averaging 2.0% inflation means the Fed has given itself room to cut rates based on inflation data alone, even if the US strikes a deal with China.

Superficially, the Fed's "dot plots" suggest no rate cut this year, but that projection dangles by a thread.  Of the seventeen Fed policymakers who made projections, one showed a 25 basis point rate hike and eight showed no change at all.  In other words, the shift of even one more official toward rate cuts would have made a rate cut the median outlook.  Eight policymakers already project a rate cut, with seven of them showing 50 bps in cuts by year end.  Notably, the median forecast for the federal funds rate at the end of 2020 is now 2.125% versus a prior estimate of 2.625%.  The median projection for the longer-run average rate is now 2.50% versus a prior estimate of 2.75%.

The Fed's statement was dovish, as well.  Economic growth was downgraded from "solid" to "moderate" and they noted a decline in "market-based measures of inflation compensation."  Later in the statement, the Fed wrote that "uncertainties...have increased" and that it will "closely monitor" incoming information and "will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent (inflation) objective."  The reference in prior statements to being "patient" about deciding on changes to short-term rates was taken out back, shot, and quickly buried in an unmarked grave.  The last key point from today's meeting is that one policymaker, James Bullard from the St. Louis Fed, dissented, voting in favor of a 25 bp rate cut at today's meeting.

The bottom line is that regardless of the likelihood of the Fed cutting rates, we think rate cuts are unnecessary.  Nominal GDP – real GDP growth plus inflation – is up 4.8% in the past two years, which suggest the Fed should be raising rates rather than cutting them. 

Nevertheless, as we stated above, it now looks like the Fed has positioned itself to cut rates in July unless the US reaches a trade deal with China and inflation turns up faster than the Fed now expects.  While the futures market suggests a July rate cut would be 25 bp, we think that if the Fed does cut in July, there is a significant chance that it could be a one and done of 50, or even 75 bps.  Cutting a small amount when the market expects further rate cuts later on creates an incentive for households and businesses to postpone activity.  So, instead, if a rate cut happens, chances are it will be larger than the market now expects.

The current environment is very bullish for equities, which would be cheap even without rate cuts.  In the meantime, holders of long-term bonds may come to regret policies that mean a faster pace of inflation over the long run.  
  
Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist

Click here  for PDF version