Don't be shocked if the Fed decides to shock the market on Wednesday


It's time to choose your own adventure for the central bank, as you can see at least a couple of different stories at hand.

Larry Downing / Reuters

For US Federal Reserve Chairman Jerome Powell and other decision-makers at the US central bank, it's time to choose their own adventure. Just as in children's books that allow you to shape your plot, it is possible for monetary policymakers to see at least a couple of different narratives in the facts available.

In one, the United States' recovery reaches its tenth birthday in an extraordinarily good form. Unemployment is at a half century low, the stock market is flirting with record levels and consumer spending is increasing. Nothing to worry about, people.

In the other story, inactive readings on manufacturing output signal an economy in rapid cooling. Bond yields are shouting that investors want shelter and want it now. This reinforces the Fed's view to cut interest rates immediately, rather than wait for further evidence of problems.

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What is the Fed's favorite story? We will find out on Wednesday when the central bank concludes its two-day meeting. The market sees only a subtle 23 percent chance of a rate cut. Instead, almost everyone expects the Fed to keep rates stable, but it sounds more accommodating as it prepares the markets for at least a couple of cuts in the coming months.

This all sounds very measured and reasonable. But nobody should be shocked if the Fed decides to shake the market and proceed with a surprise rate reduction on Wednesday.

Why? The US central bank has two big challenges right now. One is trying to decipher the true state of the economy. The other is trying to make the most of its limited ammunition.

This is the most worrying problem. During the recessions, the Fed usually cuts interest rates by five percentage points to help the economic growth of the goose and restore prosperity. At the moment, however, the rate on funds fed funds is 2.5%. This gives the Fed only half of its usual room to lower rates before it reaches zero. This is a very thin pillow.

If the US economy hits a crisis, the Fed will be able to provide only a half measure of its typical assistance. Any recession could linger and insult, the result of what the former US Treasury Secretary Larry Summers calls Japanification – "a situation in which interest rates are permanently blocked at zero and deflationary pressures are imposed".

The Fed must avoid this. And the best way to do this is by using his powers aggressively and pre-empirically. If you wait for clear evidence of a recession to emerge, you may find yourself struggling to recover an economy that is slowing down.

The risks for cutting now seem limited. Inflation expectations have fallen in the last two months and the Fed's preferred inflation measure now stands at only 1.6 percent, significantly below the central bank's 2 percent target. Should the Fed cut rates on Wednesday, and the economy will prove to be more in the form of some fear, inflation could jump – but it would arguably be a good thing.

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To be sure, not everyone agrees with this analysis. One of the strongest reasons to expect the Fed to hold the fire is the prevailing uncertainty on global trade. Donald Trump sent stock markets sky-high on Tuesday when he tweeted that he expected to have an "extended meeting" with Chinese President Xi Jinping at the Group of 20 summit in Osaka, Japan, from June 28th to 29th.

Fed policymakers will want to wait until after the Group of 20 summit to assess the economic outlook, says Greg Valliere, chief US strategist at AGF Investments. "The Fed would be reluctant to take any action until the meeting ends and we will see what comes out of it," he said.

Maybe so. But it is difficult to ignore the warning signs of stress in the US economy. On Monday, an indicator of manufacturing activity in the State of New York suffered its biggest fall in a registered month, while analysts at J.P. Morgan Chase said the chances of a recession in the United States in 2020 rose to 45%. If the Fed has to choose its own adventure in this uncertain climate, cutting rates sooner or later makes a lot of sense.

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