Forward Guidance Doesn’t Meet Reality

Even though in the few days leading up to the September Fed meeting, the CME Group FedWatch tool showed a declining chance of a rate cut (it fell to near 50%), the Fed did exactly what was expected by cutting rates on Wednesday. The CME Group tool was impacted by the selloff in the repo market. Because of this selloff in the repo market and the spike in the effective Fed funds rate, the Fed took a few additional actions unrelated to monetary policies that have an economic objective.

The effective Fed funds rate spiked from 2.13% on September 12th to 2.3% on the 17th. Therefore, the Fed lowered the IOER (interest rate on excess reserves) by 30 basis points, authorized temporary Open Market Operations, and allowed organic balance sheet expansion. Whenever the Fed does anything new it gets criticized. It’s easy to claim such action is a negative signal and that this organic balance sheet expansion is another round of QE, but it’s not, at least not yet.

Notable Dissent  

The stock market didn’t react much to the Fed’s statement because it didn’t change much. It reacted to Powell’s testimony which we will review in the next section. The most interesting aspect of the Fed’s announcement was the vote. There were 3 dissents which is the highest since 2013. It’s no surprise there is dissent because economic policy i.e. the trade war is highly unpredictable. Bullard favored a 50 basis point cut. That could be problematic because the Fed funds rate would be close to the zero bound without a recession. There would be less ammo to deal with a recession. Plus, in the event of a trade deal and cyclical upturn, the Fed could quickly have an inflation problem (even core PCE) in early 2020.

On the other hand, Rosengren and George voted for no cut. As you can see from the Fed’s dot plot above, the median estimate sees no cuts for the rest of the year and next year and then a hike in 2021. You probably shouldn’t take 2021 policy estimates very seriously since the Fed didn’t guide for any cuts this year back in June. Also, in the presser, Powell essentially stated he’s going meeting by meeting and if the data changes, policy will change. There’s not much visibility into December 2019 let alone 2021. To be clear, the CME Group FedWatch tool shows there is a 49.2% chance of a cut by the end of this year.

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