The FOMC Will Cut Rates, But Not This Month

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The Fed Just Cut Rates — but That’s Not the Biggest News

Rate cuts are typically welcomed by the market, but this one was met with volatility.

Going into the September meeting of the Federal Open Market Committee (FOMC), investors were divided on what the Fed was going to do. The futures market had a roughly 50/50 chance for either no rate cut or a 25-basis-point rate cut.

Well, we just got our answer. The FOMC decided to cut rates by another 25 basis points to a target range of 1.75% to 2%. This comes on the heels of a cut of the same magnitude in July. The stock market declined immediately after the interest rate decision was announced before rebounding into the close. Generally, when the Fed takes the more-dovish of two potential courses of action, the market immediately rises in response.

There’s a good reason for the market’s reaction today, so here’s what you need to know about the September FOMC meeting and what could be causing today’s volatility.

Image source: Getty Images.

What changed in the statement?

There are fewer documents anywhere in the world that are as closely dissected word-for-word as the FOMC’s statement that reveals its interest rate decisions. And given the trade-war and recession fears that have been present in the market recently, it may surprise you to learn that there was actually a positive changes in the statement language.

For example, the July statement said that growth in household spending had “picked up,” while it now says that it has been “rising at a strong pace,” although it did say that “exports have weakened.”

Also in the statement, we learned that three of the 10 voting members of the FOMC disagreed with the rate cut. Two wanted no cut at all, while one wanted a more dramatic 50-basis-point rate cut.

The dot plot

We knew the Fed’s dot plot was going to change significantly. If you aren’t familiar, the Federal Reserve’s dot plot is the chart that shows where Fed officials see the benchmark federal funds rate heading.

But the dot plot didn’t change as much as many investors had hoped. The new dot plot shows a median projection of no further rate cuts in 2020 or 2020, followed by one rate hike in 2021 and another in 2022. This could be interpreted as a negative by investors, many of whom are expecting a series of rate cuts to follow this one. In fact, the futures market was pricing in a median of two more rate cuts this year a week before this meeting. Immediately after the dot plot was announced, this shifted dramatically, and now no further cuts are being priced in.

Just as significant is how divided the FOMC members are. Of the 17 people who participate in the projections, seven are projecting one further rate cut, five project that the federal funds rate will remain where it is, and the other five are actually projecting one rate hike before the end of the year.

Economic projections

As I mentioned, this was one of the four Fed meetings each year where we not only get an interest rate decision, but where the Federal Reserve releases its latest economic projections. There are three main categories: GDP, unemployment, and inflation.

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  • GDP Growth The Fed now sees GDP growth at 2.2% in 2020, which is actually an increase over the 2.1% rate that it projected at the June meeting. The central bank also sees GDP growth of 2% and 1.9% in 2020 and 2021, respectively.
  • Unemployment The median projection for the year-end 2020 unemployment rate is 3.7%, which the Fed also projects for 2020 before a slight uptick in 2021. The 2020 projection is a slight increase from 3.6% last time projections were released.
  • Inflation The Fed’s inflation forecast remains exactly the same as it was in June. For 2020, inflation is seen at 1.5% (core inflation of 1.8%), rising to 1.9% and 2% over the next two years.

In a nutshell, not too much changed in the Fed’s projections this time.

The key takeaway

After reading through all of this, it’s clear that the dot plot is the part that seems to have taken investors by surprise. If anything, the 25-basis-point rate cut was a pleasant surprise, and not much changed in the statement or in the economic projections. However, the divided nature of the FOMC and the general lack of projected further rate cuts seems to be causing a mixed reaction among investors.

Very Divided FOMC Cuts Rates As Expected, Fails To Address Liquidity Crisis, Sees No More 2020 Cuts

Summary: The following critical things stand out:

  • Fed cuts both the fed funds (by 25bps to 1.75%-2.00%) and IOER (by 30bps to 1.8%) rates as expected, but does notexpect any more rate cuts in 2020; the terminal rate was kept unchanged at 2.5%.
  • The Fed has never been more divided: 7-3 vote to cut; Esther L. George and Eric S. Rosengren voted to keep rates unchanged; Bullard voted for a 50bps rate cut (guaranteeing him the job over Kashkari when Trump fires Powell); 7 FOMC members predicted another cut this year, while 10 say hold or raise.
  • Hawkish: even among the dissenters, not a single FOMC member expected more than 1 rate cut any time in the future.
  • No mention of POMOor permanent repo ops: with consensus shifting rapidly to expect some major liquidity injections from the Fed namely POMO, watch overnight repo rates explode overnight as Powell failed to provide any repo support; what the Fed did do is announce it would lower the offering rate for overnight repos to 1.70%, 5bps below the bottom of the EFFR – this will hardly be sufficient for the market.
  • In summary, Powell has dismissed the significance of funding volatility and sounds hawkish to those that saw these issues as requiring the Fed to restart POMO and grow the balance sheet again.

Best summary of today’s process:

IS THERE ANYTHING MORE EXHILARATING AND ENDORPHIN SECRETING THAN READING FED MINUTE REDLINES

Background:

As we detailed earlier, things have not gone exactly according to plan since The Fed cut rates for the first time in a decade:

But today is a big day for Jay Powell as he has to somehow explain why he is cutting rates in the face of:

Surging inflation

Dramatically positive macro surprises

Unemployment near record lows

Stocks near record highs

Bond yields near record lows

Dollar near record highs

Of course, there is the fact that policy uncertainty has never been higher.

And The Fed just suffered the biggest short-term liquidity crisis since 2007!

The market is completely priced for at least a 25bps cut today.

But, we note that markets have become more hawkish in recent weeks – shifting from expecting 2.7 rate-cuts to just 2 rate-cuts in 2020 (including today).

Perhaps, Powell has seen this chart?

If the FedEx signal is anything to go by, then we are headed for rather bad times ahead..

I have my chips on this as well.. pic.twitter.com/SRisUCSoLc

Data-Dependent, my arse.

How many dissents this time? (anticipated dissents – Esther George, Eric Rosengren and, possibly, Jim Bullard)

To check all the dovish boxes, Powell would need to: cut 25bps, suggest more to come (dovish tweaks to language), median dots adjusted lower, fewer dissents, restart QE. As BMO noted:

In terms of assumptions for the FOMC, a 25 bp cut is essentially a done deal. The statement should maintain language that the Committee “will act as appropriate to sustain the expansion” to keep the door open to future rate cuts. The dot plot will shift lower, though we’d caution against over-interpreting this forward guidance due to the divergence between modal member forecasts and monetary policy implemented with a risk-management focus. We’re skeptical that the longer-run dot will decline further from 2.5%, which should continue to provide support for long rates (5y5y is around 2% while 10y10y is closer to 2.5%).

Anyway, here’s what he did.

*FED CUTS MAIN TARGET RATE 25 BPS TO 1.75%-2%

*FED LOWERS RATE ON OVERNIGHT REVERSE REPOS BY 30 BPS TO 1.7%

7-3 vote to cut. 7 predict another cut this year. 10 say hold or raise

GEORGE, ROSENGREN DISSENT FOR NO CUT

BULLARD SEEKS 50 BPS

Bloomberg’s Key Takeaways from the Fed decision:

No surprise on main action, as FOMC cuts benchmark rate 25 basis points for a second straight meeting — to 1.75%-2% target range

The dot plot of rate forecasts is somewhat hawkish, showing a split over the need for more easing, not just in 2020 but in coming years: Seven officials see an end-2020 funds rate of 1.625%, with five at 1.875% and five at 2.125%; none see the rate going below 1.625% through 2022

Esther George and Eric Rosengren again dissent in favor of no cut, while James Bullard seeks a half-point cut; it’s the first decision with three dissents since 2020, under Janet Yellen

The Fed also lowered the interest on excess reserves rate and the overnight repurchase rate by 30 basis points, with the central bank seeking to regain control of the benchmark as money-market strains persist

The FOMC reiterates that it will “act as appropriate to sustain the expansion”; the statement contains minimal changes, mainly to note household spending gains have been “strong” while business fixed investment and exports have “weakened”; the mention of exports is new and there’s a more explicit nod to trade tensions weighing on growth

Fed officials’ economic forecasts were largely unchanged from the prior round in June; there’s a slight upgrade in GDP growth expectations, but policy makers still see the expansion slowing and nowhere near Trump’s 3% goal

And the DOT-plot adjusted.

Fed projections show no further cuts in 2020, but seven of 17 policymakers saw one more cut as appropriate

Looking at the dot plot, it’s clear there are three camps within the Fed:

Pre-emptive accommodation is not needed; we’ve already done too much

We’ve delivered the necessary amount of pre-emptive accommodation for now

More pre-emptive accommodation is needed

The Fed is now expecting 2020 fed funds rate at 1.9 where we are now.

Full Statement below:

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How Interest Rate Cuts Affect Consumers

The Federal Open Market Committee (FOMC) of the Federal Reserve meets regularly to decide what, if anything, to do with short-term interest rates. Stock traders almost always rejoice when the Fed cuts interest rates, but does a rate cut equal good news for everyone? It can be a rollercoaster. Read on to find out why.

What Is the Rate?

When the Fed “cuts rates,” this refers to a decision by the FOMC to reduce the federal fund’s target rate. The target rate is a guideline for the actual rate that banks charge each other on overnight reserve loans. Rates on interbank loans are negotiated by the individual banks and, usually, stay close to the target rate. The target rate may also be referred to as the “federal funds rate” or the “nominal rate.”

The federal funds rate is important because many other rates, domestic and international, are linked directly to it or move closely with it.

Why Does It Change?

The federal funds rate is a monetary policy tool used to achieve the Fed’s goals of price stability (low inflation) and sustainable economic growth. Changing the federal funds rate influences the money supply, beginning with banks and eventually trickling down to consumers.

The Fed lowers interest rates in order to stimulate economic growth. Lower financing costs can encourage borrowing and investing. However, when rates are too low, they can spur excessive growth and perhaps inflation. Inflation eats away at purchasing power and could undermine the sustainability of the desired economic expansion.

On the other hand, when there is too much growth, the Fed will raise interest rates. Rate increases are used to slow inflation and return growth to more sustainable levels. Rates cannot get too high, because more expensive financing could lead the economy into a period of slow growth or even contraction.

Financing

The Fed’s target rate is the basis for bank-to-bank lending. The rate banks charge their most creditworthy corporate customers is known as the prime lending rate. Often referred to as “the prime,” this rate is linked directly to the Federal Reserve’s target rate. Prime is pegged at 300 basis points (3%) above the target rate. 

Consumers can expect to pay prime plus a premium depending on factors such as their assets, liabilities, income, and creditworthiness.

A rate cut could help consumers save money by reducing interest payments on certain types of financing that are linked to prime or other rates, which tend to move in tandem with the Fed’s target rate.

Mortgages

A rate cut can prove beneficial with home financing, but the impact depends on what type of mortgage the consumer has, whether fixed or adjustable, and which rate the mortgage is linked to.

For fixed-rate mortgages, a rate cut will have no impact on the amount of the monthly payment. Low rates can be good for potential homeowners, but fixed-rate mortgages do not move directly with the Fed’s rate changes. A Fed rate cut changes the short-term lending rate, but most fixed-rate mortgages are based on long-term rates, which do not fluctuate as much as short-term rates.

Generally speaking, when the Fed issues a rate cut, adjustable-rate mortgage (ARM) payments will decrease. The amount by which a mortgage payment changes will depend on the rate the mortgage uses when it resets. Many ARMs are linked to short-term Treasury yields, which tend to move with the Fed or the London Interbank Offered Rate (LIBOR), which does not always move with the Fed. Many home-equity loans and home-equity lines of credit (HELOCs) are also linked to prime or LIBOR.

Credit Cards

The impact of a rate cut on credit card debt also depends on whether the credit card carries a fixed or variable rate. For consumers with fixed-rate credit cards, a rate cut usually results in no change. Many credit cards with variable rates are linked to the prime rate, so a federal funds rate cut will typically lead to lower interest charges.

It is important to remember that even if a credit card carries a fixed rate, credit card companies can change interest rates whenever they want to, as long as they provide advanced notice (check your terms for the required notice).

Savings Accounts

When the Fed cuts interest rates, consumers usually earn less interest on their savings. Banks will typically lower rates paid on cash held in bank certificates of deposits (CDs), money market accounts, and regular savings accounts. The rate cut usually takes a few weeks to be reflected in bank rates.

CDs and Money Market Accounts

If you have already purchased a bank CD, there is no need to worry about a rate cut because your rate is locked in. But if you plan to purchase additional CDs, a rate cut will result in new, lower rates.

Deposits placed into money market accounts (MMAs) will see similar activity. Banks use MMA deposits to invest in traditionally safe assets like CDs and Treasury bills, so a Fed rate cut will result in lower rates for money market account holders.

Money Market Funds

Unlike a money market account, a money market fund (MMF) is an investment account. While both pay higher rates than regular savings accounts, they may not have the same response to a rate cut.

The response of MMF rates to a rate cut by the Fed depends on whether the fund is taxable or tax-free (like one that invests in municipal bonds). Taxable funds usually adjust in line with the Fed, so in the event of a rate cut, consumers can expect to see lower rates offered by these securities.

Because of their tax-exempt status, rates on municipal money market funds already fall beneath their taxable counterparts and may not necessarily follow the Fed. These funds also may be linked to different rates, such as LIBOR or the Security Industry and Financial Markets Association (SIFMA) Municipal Swap Index.

The Bottom Line

The Federal Reserve uses its target rate as a monetary policy tool, and the impact of a change to the target rate depends on whether you are a borrower or a saver. Read the terms of your financing and savings arrangements to determine which rates are relevant to you to determine exactly what the recent Fed cut means for your wallet.

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