Fed rhetoric

The US economy has been softening in a gradual way during the past few months. The weakness has been in investment (both business and housing), employment, manufacturing and trade, but it is by no means pervasive. Consumer spending has remained buoyant, and equities have held up.

This kind of mid-cycle slowdown is not unusual during a business cycle expansion, and often follows a series of interest rate increases such as the Fed has engineered over the past three years. It happened, for example, in 1995-96. It is also normal for fiscal stimulus - such as that enacted by President Trump’s tax cuts at the end of 2017 - to provide an initial boost, followed by a relapse as the financing requirements of the government start to impact financial markets. 

Funding the deficit

In the current case, compared with a year ago, the federal government is issuing approximately US$1 trillion of new debt (to fund the deficit), and in addition the Fed was, until 31 May, disposing of Treasury securities at a rate of US$30 billion per month, or US$360 billion p.a. 

Added to disposals of mortgage-backed securities, this has meant that the private sector has been required to absorb around US$1.4 trillion on an annual basis. Fortunately for the markets, the Fed’s disposals have been scaled down since 31 May, and will come to an end in September.

Shift in monetary policy

Moreover, the members of the FOMC shifted policy abruptly following their last interest rate increase in December 2018. This “pivot” towards easing has not yet been reflected in actual interest rate cuts from the current Fed funds target of 2.25-2.50%, but the language of Fed governors and presidents as well as the text of the 30 January, 20 March and 1 May FOMC statements has been clearly signalling some degree of easing ahead. 

Lower interest rates

The cut in interest rates could perhaps come as early as 31 July when the FOMC concludes its next meeting, but there will be opportunities in September and possibly again in December when the FOMC is scheduled to release participants’ forecasts such as the famous dot-plot for interest rate changes over the next 2-3 years.

Again, adjustments to interest rates after the initial normalisation phase have happened in the past and should be considered a sign that FOMC members are attempting to extend the cycle. Following the rate increases of 1994-95, this occurred in 1995-96 when the Fed cut rates, and there were several further adjustments until the end of the cycle in 2001.

The key question for investors is not so much when the FOMC will cut interest rates, but whether those rate cuts will be accompanied by any material change in the rate of growth of broad money and bank credit. 

The reason is that the current deceleration of the US economy and the fall in inflation is in large measure a result of banks only growing their balance sheets at very modest rates of 4-5% over the first six months of 2019. 

Outlook

For stronger nominal GDP growth, faster broad money growth is required.

My forecast is for 2.6% real GDP growth and 1.5% CPI inflation in 2019.