Ohio State’s Woody Hayes used to say that his problem with the forward pass was that “Three things can happen, and two of them are bad.” Well, after Chairman Powell’s testimony last week, the FOMC may find itself in a similar position, only maybe worse.
The Committee can do three things – lower rates, keep rates steady, or raise rates – and in this case all three options have potentially negative consequences. Let us consider the kinds of fallout that might occur from each, starting with the easiest option, raising rates.
Raise Rates – Clearly, if this option were selected, it would totally surprise everyone – markets, both bond and equity, as well as politicians. Such a move would negate all the messaging that has preceded the FOMC’s upcoming July meeting and make the Committee look erratic and out of touch with what is going on in the economy. Criticism about competency would also be leveled. Such a move has no probability of happening.
Keep Rates As Is – Opting not to change rates would also be a surprise to markets and would have to be sold based upon yet-to-be seen incoming data. While there is a host of forthcoming data, the first estimate of second-quarter GDP is critical. The FOMC and Chairman Powell will be hard pressed to sell a no-rate-decrease policy, especially after having glossed over the most recent jobs report. The second-quarter GDP number will further expose the divisions within the FOMC about when and whether a rate change is warranted. Reserve bank presidents Bostic and Barkin have now gone on record as not being convinced that a rate move is needed, and other reserve bank presidents will be speaking before the July meeting on both sides of the issue. Finally, no change would also fuel additional speculation about the next and subsequent meetings. This is the Chinese water torture policy option.
Lower Rates – The riskiest option of the three for the FOMC may be to move rates down, by say 25 basis points. Chairman Powell has already attempted to justify a rate cut because of uncertainties about global growth and trade issues. The best that the FOMC can hope for is a sub-trend second-quarter growth number, whereupon they could attempt to sell the rate decrease as an insurance move to keep the expansion moving.
There are several problems with this strategy. The first is political. Regardless of the stated rationale, President Trump will point to the fact that the FOMC’s move confirms his assertion that the last rate increase was too much, that he was right and the FOMC was wrong, and that they didn’t know what they were doing. His access to the media and his captive audience far outweigh that of the Fed, so the FOMC’s voice will be drummed out. Most unsettling would be the perception that the FOMC caved to political pressure and has now put its independence at real risk, inviting even more armchair policy making, notwithstanding recent expressions of support by people on both sides of the aisle at the recent congressional hearings. Not only is there a critical threat to the Fed’s independence, but also a rate decrease will only give rise to market participants arguing for at least an additional 75-basis-point reduction through the end of the year. Thus, the drumbeat for more and more accommodation would continue, and the FOMC would face increased market and political pressure to deliver more. In other words, a 25-basis-point move solves nothing, holds little chance of being credibly sold, uses up valuable policy flexibility in the case of a recession threat, and only creates more problems going forward.
The Messaging Problem – At this point the FOMC faces a real messaging problem. To illustrate, Chairman Powell repeatedly emphasized the problem of uncertainties about a global slowdown and tariffs in his recent monetary policy testimony. For an economist to use the term uncertainty means that he or she cannot estimate the probability that an event will occur or what its consequences will be. On the other hand, to use the term risk means that one has a view about the likely probabilities associated with the events of concern. There are no economic models that can provide any meaningful guidance as to what the consequences of a policy move to counter uncertainties are or will be. We do have some ideas about how to address risks. To complicate matters even more, either a trade war or a global slowdown is unlikely to have a measurable impact on the core of our economy. Trade is a small portion of GDP, and the so-called trade uncertainties that have been in place as of last year had no noticeable impact on first-quarter GDP growth, which came in at 3.1%. In fact, the most recent data indicate that our trade deficit with China has actually increased rather than decreased, in spite of the tariffs that have been put in place. The impact of a global slowdown are also questionable. Global growth has been slow for at least a year, and it isn’t clear how it has affected us or what impact an “insurance” policy rate cut might have or how big it should be.
In short, unlike in the case of the forward pass, where at least one positive result might be realized, the FOMC has painted itself into a corner where none of the three options available to it in the short run are likely to result in positive outcomes, either economically or politically.
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