We were recently asked by one of our esteemed clients when we thought the Federal Open Market Committee (FOMC) would start cutting the federal funds rate target. The answer is the title of this piece.
What follows is why we replied that way.
The chart below shows us the conditions under which Mr. Jerome Powell, the chair of the Federal Reserve Board, and the final authority on where the federal funds rate target will be set, will be pondering his three problems.
MacKay & Company
Problem No. 1 is the presence and location of the red dots on the chart. For those of you who don’t speak “bond,” an inverted yield curve is the condition where you are paid a higher rate of interest for a short-term security than you would be for a long-term security. Currently, you will get more interest from the six-month treasury bill (5.43%) than you would from the 10-year treasury note (4.45%).
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The relative scarcity of red dots is your first indication this is not the normal state of affairs. But their location, immediately in front of the last four recessions, is a warning that time is of the essence if Mr. Powell is to keep his pledge of not letting the economy slide into a full-fledged downturn.
So, Mr. Powell’s first problem is to decide on when and how to make the red dots go away.
Mr. Powell’s second problem is one of his own making. And that was his choice of an inflation metric, the Core PCE, that is not behaving the way he hoped it would. Namely, that the year-over-year percent change in the Core PCE would be quickly approaching the 2% target that was chosen at the outset of this policy exercise. The reasons why the Core PCE is not behaving as expected have mostly to do with the level and trend of shelter prices, which respond to changes in monetary policy with a long lag.
All of which goes back to the first problem — how and when to make the red dots go away. Mr. Powell would like to do that sooner rather than later, but he is constrained by how he set his victory conditions.
Mr. Powell’s third problem is one every Fed chair faces every day, how to communicate changes in policy without unbalancing the financial markets.
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By unbalancing, we mean preventing both the bond and the stock market from becoming one-way trades. That is some jargon relating to the condition where everyone is buying, or everyone is selling at the same time. This is extremely dangerous because it leads to the types of excess that have created a great deal of collateral damage.
The next FOMC policy announcement will come on June 12. Between now and then you can expect to see several FOMC members on the tape floating ideas about what the next policy move should be.
Pay close attention to any comments by Federal Reserve board members or one of the four voting regional bank presidents. That is what the stock and bond traders will be doing. What those policy options are will tell us how many of Mr. Powell’s problems might be addressed and, possibly even solved, over the next several months.
