Federal Reserve officials are holding the second day of their two-day June meeting Wednesday under pressure from the U.S. president and financial markets to reverse at least some of last year’s interest rate hikes.
Most investors and economists expect that the Fed will hold rates steady at the meeting but signal that they are likely to cut rates later this summer, perhaps at their July meeting. That signal could come in a change in language in the Fed’s statement and from the post-meeting press conference with Fed chair Jerome Powell. Market measures of expected interest rates, which are not always accurate, suggest interest rate traders expect the Fed to cut rates three times this year.
President Donald Trump on Tuesday once again seemed to be criticizing the Fed in a series of tweets about the European Central Bank’s signal that it would deploy stimulus the summer if the pace of economic growth did not pick up. The euro weakened against the dollar, which could make European exports more attractive globally, and European stocks indexes rallied.
“I just want a level playing field,” Trump said to reporters.
The Fed hiked interest rates four times last year, most recently in December. Early last year, the official forecasts of Fed officials showed they expected to raise rates at least three times this year, continuing its policy of gradually raising its interest rate target. The Fed has also been shrinking its balance sheet by letting some of its bond holdings run-off as the bonds mature.
Trump began openly criticizing the Fed last summer, arguing that the hikes were hampering his efforts to accelerate economic growth. While Fed officials never responded directly to Trump’s complaints, in their official statements they argued that their hikes were not intended to stymie growth. They claimed that their policy was aimed at extending the now record-long economic expansion while bringing interest rates closer to historical norms after several years of ultra-low rates that followed the financial crisis and Great Recession.
Financial markets panicked in the last three months of 2018, culminating in a crescendo of selling in December of 2018. While some investors blamed both heightened trade tensions for the sell-off, a December agreement between the U.S. and China to restart trade negotiations and hold off on further tariff escalation did little to bolster the market. Many investors feared the Fed was signaling that monetary policy was on auto-pilot and rates were headed up despite some signs of economic weakness. This raised the prospect that the Fed could mistakenly push the U.S. into a recession.
The Fed changed its policy in January. Instead of gradually raising rates, the Fed announced it would now be patient. Still, though, official Fed forecasts implied that they would hike rates at least one more time in 2019. This shift placated investors and stocks rallied. Economic growth came in at better than expected, showing the economy grew at a better than three percent rate in the first three months of the year.
Trump, however, continued to criticize the Fed. His two picks to fill seats on the Fed board, businessman Herman Caine and conservative economic pundit Stephen Moore, were forced to withdraw themselves from consideration after it became apparent that Senate Republicans could not muster enough votes to confirm them.
At the heart of Trump’s dispute with the Fed is a disagreement about the potential of the U.S. economy. The Fed foresees the economy growing about 2 percent this year and thinks the long-term growth path is slightly below 2 percent. Growth above that level is seen as the economy performing “above potential” and as risking an acceleration of inflation. In most of the economic models deployed by the Fed, the very low level of unemployment recorded last year and this year would indicate that interest rates should be rising to stave off possible “overheating” and inflation.
Trump and his closest economic advisers think the potential growth of the economy is much higher. They are aiming for 3 percent growth this year and think the economy could grow as much as four percent. Trump’s tax cuts and push to reduce the regulatory burden on businesses were aimed at encouraging investment, raising productivity, and pushing economic growth higher.
Inflation has remained surprisingly low, defying predictions that a tight labor market would push up price levels. Most recently, the personal consumption expenditure index–the Fed’s favorite inflation gauge–came in at 1.5 percent, well below the 2 percent Fed target. Inflation has consistently undershot the Fed’s target for years, prompting some to speculate that the Fed’s target of 2 percent is in effect a ceiling rather than a target.
Fed officials insist that the target is “symmetrical,” meaning deviations below the target are as undesirable as deviations above the target. This, however, may make the Fed’s failure to hit its target more problematic. It implies that the Fed either lacks the policy tools to hit the target or has incompetently deployed its tools. Another alternative explanation is that inflation is just taking longer to reach the target than expected. At least some Fed watchers have said that the Fed has acted as if it were actually targeting a lower level of inflation than it claims to be.
Consistently undershooting the inflation target poses the risk that the public’s expectation for prices could move lower to match recent experience. In the view of most Fed officials, inflation expectations are an important cause of actual expectations. If inflation expectations become “anchored” at too low of a level, it becomes harder to move inflation to the Fed’s target. The University of Michigan’s recent survey of consumer sentiment showed that inflation expectations fell in June to their lowest level in at least forty years.
Trade policy has been another source of uncertainty and surprise over the past year. The Trump administration imposed tariffs on steel and aluminum in the spring of 2018, saying tariffs were necessary to protect industries vital to national security from price levels for the metals depressed by Chinese overproduction. Many business leaders and economists predicted that higher metals prices would push up consumer prices as producers passed on the costs of the tariffs.
That did not happen. Prices of metals rose but were largely absorbed in the chain of production, indicating that businesses have not been able to pass on the costs and have instead allowed profit margins to contract. Prices on store shelves or car showrooms fell or remained in line with the low level of inflation seen in the rest of the economy. It may be that the Trump tax cuts, which have boosted after-tax returns for businesses, created more room for tariffs to be absorbed by businesses.
The China tariffs have followed a very similar path. When Trump began to impose tariffs on China last summer, starting with a 25 percent tariff on a basket of mostly high-tech goods used by U.S. businesses, critics said they would raise consumer prices. Those claims became more amplified when the Trump administration imposed a 10 percent tariff on $200 billion of Chinese goods.
But higher prices did not follow. The tariffs on China have instead been absorbed by a combination of U.S. importers accepting lower margins, China’s currency falling in value against the dollar, Chinese producers lowering prices, and U.S. companies shifting production to other low-cost countries not subject to the tariffs. Some critics continue to say that the tariffs will eventually raise prices, although these claims have lost much of the credibility after several months of tariffs.
The failure of a tight labor market and tariffs to raise prices may have caught Fed policymakers by surprise, suggesting that at least the last hike was made based on inaccurate forecasts.
More recently, the U.S. economy has shown some signs of sluggishness. Consumer sentiment has fallen from all-time highs, although it remains at an elevated level. Job creation in February and May was low by recent standards and lower than most economists had forecast–although still high enough to keep the unemployment level at or near its 50 year low. Growth in the manufacturing sector, which is just 12 percent of the economy but often serves as a bellwether for approaching economic contractions, has slowed and some regional surveys even suggest activity has contracted.
Critics of the Trump administration have been quick to point to the tariffs as a drag on the economy. The brief threat of tariffs on Mexican goods may have created a heightened level of anxiety given the complex and deep ties that have developed between the U.S. and Mexican economies over the last three decades. But it is far more likely that sluggish economic growth in Europe and elsewhere around the globe has depressed demand for U.S. goods and services than that tariffs are playing much of a role.
The Fed is likely to respond somewhat elliptically to recent economic data. Many Fed watchers think they will drop the word “patient” from their official statement, indicating that they will act quickly to keep the economic expansion going. The very word that once reassured markets is now seen as “stale” and many fear a patient Fed would cut rates too late. The Fed could also add language to their statement indicating that they stand ready to “act as appropriate to sustain the expansion,” a phrase Chairman Powell used in remarks earlier this month.
If the Fed does not make at least some of the expected changes to its statement or if Powell conveys a message of hesitancy on rates, financial markets are likely to react by selling off-risk assets and bidding up U.S. Treasuries, pushing yields down. Fed officials are all too aware that each word of the statement will be closely parsed and weighed by investors.
The Fed could also cut its interest rate target. There seems little to gain by holding off until July, especially if the Fed is basically sending a message that a cut is coming soon. Markets are not quite prepared for a June cut but it would not come entirely as a shock. The futures market suggests that there is about a 20 percent chance of a cut this month. And, indeed, surprising the market with an aggressive move would lead little doubt about the Fed’s ability and willingness to act.