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Fed Likely to Cut for the First Time Since 2015

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The Federal Reserve will be concluding its two-day monetary policy meeting today. This will culminate with the release of the monetary policy statement.

For the first time since 2015, the central bank will be most likely cutting interest rates by 25 basis points. This would bring the short term Fed funds rate down to 2.20% – 2.25%.

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The Fed funds rate has been in a steady incline since December 2015. In response to the global financial crisis, the central bank had lowered interest rates to historic lows of 0.50%. However, after nearly a decade since then, the Fed started to raise rates gradually.

This pushed up the Fed funds rates from the historic lows of 0.5% to 2.50%.

U.S. Fed Funds Rate
U.S. Fed Funds Rate

The rise in the US interest rates was in response to a gradually improving economy.

After growth faltered in 2007 – 2008, the US economy was supported by the Fed’s unconventional tools which included injecting liquidity into the economy.

Over the years, the central bank’s efforts have paid off as the US economy quickly turned higher.

How Did We Get Here?

Today’s policy decision is in response to the prospects of a slowing US economy. Up until the previous governors, the Fed was always seen as responding to a crisis after it happened. For the first time, we will see the Fed taking a proactive approach.

Given the fact that the US economy is currently in the midst of the longest economic expansion, investors and markets at large are concerned about the threat of a recession.

This was evident from earlier this year as the US treasury yield curve inverted, a historic signal that predicts a recession. However, analysts were quick to dismiss its reliability. On the ground level, there are a lot of issues currently plaguing the US economy.

U.S. GDP, Q1 2019
U.S. GDP, Q1 2019

The US economy grew at an annualized pace of 3.1% in the first quarter of this year. However, growth has steadily slowed ever since GDP grew 4.2% on an annualized basis in the second quarter of 2018.

Recent economic data showed that according to the initial GDP estimates, the US economy grew at an annualized pace of 2.1% in the second quarter of 2019.

There are a number of reasons behind this.

For one, the Washington administration is currently actively pursuing trade as leverage against its trading partners. China, has been the worst hit. President Trump has raised tariffs on imports from China as well as a few other countries.

The basis for the trade wars was an effort to rein in the ballooning trade deficit that the US has with most of its trading partners. The United States imports more goods than it produces.

What Comes Next for the Fed?

While the rate cut is highly expected in the markets, questions remain on what the future policy course might be. The central bank, in its June Fed meeting, indicated that it expects no rate hikes for the remainder of this year.

President Trump, and the markets, to a certain extent, were initially pricing in a 50bps rate cut. This was in response to slowing manufacturing as well a somewhat sluggish labor market data.

In June, the US nonfarm payrolls surprised by showing a 220k increase in jobs. This was higher than expected and comes after a weak spell.

Various FOMC members have grown more vocal in recent times about taking precautions. Just last week, NY Fed President Williams signaled that the Fed should cut rates by at least 50 basis points.

However, officials downplayed the comments signaling that the markets could expect to see just a quarter-point cut. At this point, it is unlikely that the Fed will take an extreme step to lower rates by 50bps.

On the contrary, we could expect to see the Fed wait for the response from lower interest rates and then act accordingly.

A lot will depend on today’s forward guidance that the Fed will issue. In the near term, it is likely that the Fed will wait for the final GDP figures for the second quarter and perhaps wait for the initial GDP estimates for the third quarter before responding with policy measures.

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