Or is the Market Forcing Their Hand?
After Friday’s disappointing jobs report the odds for a July Fed rate cut jumped to nearly 80%. We are careful to read too much into the jobs report considering there were at least 70K employees who were unable to work due to the bad weather. There were an additional 272K workers who would normally work full time that had to work part-time due to the bad weather across most of the country. From a seasonal basis, May usually sees ~50K employees who can’t work due to weather.
Despite the disappointing jobs report, the labor market remains on solid footing. Not only is the unemployment rate at the lowest level since 1969 but the trailing 12-month sum of payroll additions is 2.35 million. Although employment is a lagging indicator, the recent strength does not suggest that an economic recession is imminent. For example, since 1940 the average 12-month sum of payrolls in the one year before a recession is 1.7 million. So if the Fed has a dual mandate of stable inflation and full employment, is it warranted to cut rates with a labor market this strong?
Our answer is yes. It may be too soon to say that three rate cuts are necessary before the end of the year like the futures market is suggesting, but we do believe a fine-tuning in rates is warranted to support the expansion. It is not abnormal for the Fed to tweak rates in a prolonged economic expansion, especially with the unique environment we are in (e.g. trade squabbles, stubbornly low inflation).
In fact, in two of the last three expansions (1982-1990 and 1991-2001), the Fed paused and cut rates to support the expansion. The most notable was the rate cuts during the mid-cycle slowdown in the 1990s. After tightening policy for all of 1994, three rate cuts were warranted in 1995 and the expansion continued until 2001. Therefore, Fed rate cuts do not mean the expansion is coming to an end. History actually suggests they are a tool to further the expansion.
While the bond market has been pushing the Fed’s patience by inverting (10YR – Fed funds rate) the most since 2007, there are other factors that support a Fed rate cut.
- Inflation stubbornly low: The Fed’s preferred inflation measure (PCE Core YoY) has been below their 2019, 2020 and 2021 target range for four consecutive months. Given that one of the Fed’s mandates is stable inflation, the recently soft inflation can justify a rate cut. The FOMC has said the inflation weakness is “transitory.” However, consumer and investor inflation expectations are a good indicator for inflation. If a consumer expects lower prices in the future, they may delay spending which can lead to a disinflationary environment. Long term breakeven rates (investor inflation expectations) are near year to date lows and 12 month forward consumer inflation expectations according to the Conference Board are near a 15 year low.
- Manufacturing weakness: The U.S. ISM Manufacturing Index has fallen in three of the past four months and while still in expansion territory, it is at the lowest level since October 2016. The production component, a good indicator for future growth is nearing contraction territory (at 51.1) and is near a three year low. While manufacturing is being negatively impacted by the trade “squabbles” and could turn around as negotiations materialize, the Fed may want to be proactive in order to support the expansion. In addition, the manufacturing weakness is not isolated to just the US. The JPMorgan Global Manufacturing Index dipped into contraction territory in May (at 49.8). Of the five largest countries in the world (U.S., China, Japan, Germany, and UK) the U.S. and China are the only two that have manufacturing indicators in expansion territory and their indicators have been falling. Japan, Germany and the UK’s indicators are in contraction territory.
- Summary: The negative stigma around the Fed cutting rates and what it must insinuate for the future of economic growth is unfounded. History has shown that the Fed tinkering with rates in the middle of a long term tightening cycle does happen and has not meant that a recession is imminent. It can be seen as the pause that refreshes the cycle. There is no reason to suggest that it can not happen in the current economic cycle. A solid U.S. consumer and low-interest rates should support a continuation of the expansion.