Federal Reserve Board (Fed) Chairman Jerome H. Powell announced on June 4 that the central bank is prepared to sustain an economic expansion should the trade dispute with China weaken the economy. Market participants read into his remarks an intention to cut interest rates, and enthusiasm over the prospect generated enough buying action to move the markets up smartly. Of course the Fed never made such a promise, nor is it ever likely to do so. Thus the market’s response, set against the Fed’s cautious words, raises two questions for any investor:
- What is the Fed actually planning?
- Over what time period will the policy change develop?
Question 1: If and when the Fed acts, it will do so with a rate cut, but otherwise, matters are far from definite. Powell has not promised a rate cut, but neither has he taken one off the table.
Powell has been equivocal for good reason. The Fed cannot forecast its policy moves: doing so would create major risk by inviting market participants to base their trading decisions entirely on that forecast. As well, the Fed cannot forecast any better than anyone else, and Powell and his policy team know that. If the Fed were to forecast one way and then see unanticipated conditions develop, it would have to change its plans, and even if it did so in a minor way, everyone in the market would have to adjust almost simultaneously. The consequent disruption would be huge. It’s better that the Fed keeps its (always tentative) plans secret, so that market participants settle on a variety of positions. Then, should the Fed have to shift policy, not everyone would have to change.
With this constraint in mind, a natural question would be: “Why say anything?” And usually, the Fed refuses to speak. But in the present environment, Chairman Powell probably had two reasons to make a statement.
First he could see that market participants were worried about the negative effects of the U.S.-China trade dispute. Even if that dispute ends with a favorable trade deal, worries during the run-up to such a deal could itself do economic harm. Not only has it depressed the stock market until recently, but if concerns become more widespread, they could dissuade consumers from spending and, more significantly, convince businesses to hold back on hiring and expansion plans. The economy itself could falter from this negative psychology, creating a self-fulfilling prophecy of economic trouble.
The second reason is that Powell and his Fed team have no idea how long the trade dispute will drag on. They, too, must share concern about the extent of the trade dispute’s economic ramifications. They want the country to know they are not asleep at the switch, but at the same time they cannot know if, or when, they will have to respond. This brings us to the second question –– over what period of time will a change in Fed policy occur?
Question 2: Here, too, the answer is frustratingly vague. The Fed cannot know if it will have to shift policy, or when it will have to do so: All will depend on the flow of economic data. Signs of economic weakness — whether caused by trade disputes or by worries over the trade disputes — will prompt a Fed reaction, one that would almost certainly involve an interest rate cut, probably of modest size, at least initially. For now, the balance of economic data looks pretty good. The first quarter’s real growth was strong, so even in the face of a sudden weakening, the Fed would likely hold off acting until it was convinced that the new, weaker picture was real and not just some quirk in the data. Indeed, if history is any guide, the Fed would likely wait for 2-3 months data before acting, because a premature policy move can cause far more harm than a delayed one. This would mean that if suddenly in June the data turned weak, a rate cut would likely wait until the fourth quarter, and each month that shows signs of strength would delay such a cut accordingly.
A Last Word
Fed policy on raising or lowering interest rates is a frustratingly uncertain process, and many have expressed their disapproval of how those in charge proceed in such matters. But the Fed’s process leads less to a decision based on its preferences than on a recognition of this reality: the Fed cannot forecast, and in this moment’s case either the direction of trade negotiations or their likely economic effects, and that a false move by the Fed would do more harm than a month or two of delay. The Fed’s process is one of necessary prudence.