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Our views 09 July 2020

Will the Fed fall short?

By Melanie Baker, Senior Economist

5 min read

The market’s expectations for the US Federal Reserve (Fed) have changed dramatically over the past year. Having expected the Fed to hike rates in 2019 as recently as December, Fed funds futures are currently pricing nearly three cuts by the end of the year, with another expected by the end of 2020.

The case for cuts is clear enough. Global trade tensions escalated in the Spring, the best of Trump’s fiscal stimulus effects are behind us and much of the global economic data has continued to disappoint already downgraded expectations, with the global composite Purchasing Managers’ Index (PMI) trending downwards over many months.

The Federal Open Markets Committee’s (FOMC’s) June meeting validated market expectations of rate cuts, with the Fed taking a more dovish tone as eight members indicated a rate cut and the word “patient” was removed from its statement (see 'Fed opens the door to a rate cut blog piece').

We think that there will be a rate cut this year (see Trade versus Stimulus Investment Clock Economic Update), and that a further cut is a decent probability. But there is room for investor disappointment.

Image is a visual representation of the wage Phillips curve as described in the text on the page.

Source: Thomson Reuters Datastream as at 15/05/2019

As the chart above shows, after disappearing post-crisis, the wage Phillips curve is back in action. This means that the record low rates of unemployment have been boiling over into higher wages. So far, the impact of higher pay growth in inflation appears muted (helped by some recovery in US productivity growth), but signs of increased pass-through might quickly unnerve some policymakers.

At the same time, it is possible that trade tensions de-escalate further, that business sentiment reacts positively to the apparent current tariff ‘truce’ between the US and China – assuming it holds, or that a further dose of Chinese economic stimulus supports a turn in the downward trending economic data. 

With considerable monetary policy easing still priced in by markets, there is a risk that changing Fed expectations continue to prompt significant moves in asset prices.

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.