How a Fed Rate-Cut Plan Might Play Out | Lord Abbett
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Economic Insights

Policymakers likely will focus on the so-called “natural’ rate of interest. Here’s a closer look at what that means.

The U.S. economic expansion is poised to set a record for longevity, based on data from the National Bureau of Economic Research, and yet the U.S. Federal Reserve (Fed) is widely expected to deliver a 25 basis point (bps) interest-rate cut at the end of its next policy meeting on July 31. What’s going on here? What would prompt policymakers to deliver further accommodation even as the U.S. economy remains reasonably strong?

The answer, we believe, has to do with the so-called “natural” rate of interest—the theoretical interest rate that supports the economy at full employment and maximum output while keeping inflation constant. We think a 25 bps cut in July is baked in to market expectations because the Fed has lowered its estimate of the natural rate, as reflected in the so-called terminal fed funds rate. The latter rate represents the median projection of Fed policymakers’ longer-run expectation for the fed funds rate, as compiled in the famed “dot plot” chart that accompanies Fed policy statements in March, June, September, and December.

A Practical Application of the “Natural” Rate of Interest
Take a look at the chart below. With the upper bound of the fed funds target range now at the 2.5% natural rate estimate, but inflation receding further below the Fed’s 2% medium-term target, we believe the Fed has to cut rates to ensure policy remains accommodative. In our view, that’s what the 2% inflation target means—monetary policy must remain accommodative as long as inflation remains below 2% and isn’t expected to rise sharply. The Fed now has to cut rates by a quarter point at the end of July to make that clear to the markets, in our opinion.



But the Fed does not need to keep cutting if inflation remains below 2%; it just needs to stay accommodative. That’s why the Fed could tighten multiple times in 2017-2018 while inflation was below 2% the whole time; it remained accommodative throughout that period because the actual rate was well below its natural rate estimate.

Market Expectations and the Fed’s Next Move
The Fed appears to have had some difficulty in communicating that strategy, perhaps because the natural rate is such an abstract idea. However, we believe they care deeply about communication with the market and that is why they use applicable language from prior policy statements to signal what they intend to do in the short run.

From that perspective, the Fed has more or less committed to 25 bps at the July meeting by using the specific language they used in June. The portion of the statement below is exactly what it has said after a number of prior meetings right before rate cuts at the next one (and reinforced by remarks from Fed chair Jerome Powell prior to his July 10 testimony before the U.S. House Financial Services Committee). That is not a coincidence.

In light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion [our emphasis], with a strong labor market and inflation near its symmetric 2 percent objective.

In summary, we think the Fed has more or less telegraphed or promised a rate cut at the end of July, regardless of the strength of the economy. There may be one more 25 bps cut to follow in September, in our view, at which time the Fed may hit the pause button on further moves. We believe those actions should be sufficient to return the central bank to an accommodative posture, and back in line with policymakers’ conception of the inflation targeting framework. Those market participants expecting a total of four rate cuts may be disappointed, but the Fed’s clear desire to keep the expansion moving ahead while maintaining inflation near its stated target should be a positive factor for risk assets in the months ahead, in our view.


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