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The Fed is under pressure

WASIF LATIF 30-Jul-2019

The Federal Reserve met market expectations when it cut interest rates by 25 basis points (0.25%) this week. Now the pressure on the central bank starts escalating, given that the futures market envisions another cut in September and perhaps a third in December.


A solid argument can be made that the Fed doesn’t need to cut rates at all right now, to say nothing of three times in a six-month period. The U.S. economy isn’t going gangbusters, but it is growing at a decent clip. The jobless rate is at a 50-year low, wages are rising but not to the point of stoking inflation, second quarter earnings are surprising to the upside, and July saw a strong bounce in consumer confidence.


But the Fed is feeling pressure to cut from all sides. The president has sounded a steady Twitter drumbeat for lower rates, and investors have totally bought into the notion of cuts to fuel another leg up in asset prices even as valuations become ever harder to justify.


There’s also pressure for the Fed to get back into step with other key central banks. Both the European Central Bank and the Bank of Japan have clearly signaled that they are prepared to push their rates deeper into negative territory to try to spark economic growth – without Fed cuts, the U.S. dollar could further appreciate and hurt exporters.

 



And there’s the pressure the Fed puts on itself – since the financial crisis, it has zealously protected both the economy and markets. Now that both appear to be late in their respective cycles, the central bankers may be thinking, is this the time to yank away that support?


So, the Fed is in a tight box, built in part with its own hands. The first cut this week was the easy one, but it won’t be enough to satisfy markets. To stop now, short of all the priced-in rate cuts, risks causing a sharp volatility spike.