What if the Fed disappoints?

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Market pricing for tomorrow’s rate cut has moved around a lot in the last few weeks. According to the CME FedWatch Tool pricing has flip-flop between high and low probabilities of a 50 bp move and is now suggesting a 63% chance of 50 bp. With this divided view, the Fed can’t avoid surprising (and disappointing) observers. Going 50 bp will surprise those expecting 25 bp (the Fed is panicking!), while going 25 bp will be an even bigger surprise to those expecting a 50 bp move (the Fed is way behind the curve!).

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Political Economy: Damned if you do, damned if you don’t

From a political perspective, this is a no-win situation for the Fed. Trump has already said that any rate cut would be a politically motivated gift to Democrats. ?Some Republicans will also spin the cut as a sign the economy is in trouble, particularly if it is a larger than normal 50 bp cut. On the other side of the aisle, a 25 bp cut would be greeted with disappointment by many Democrats. In my view, just enumerating the various political responses shows why it is a waste of time for the Fed to try to placate politicians. Logic, consistency, and objectivity are clearly out of fashion in Washington these days.

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In my view, the Fed understands that the best course of action is to focus on fundamentals and communicate as clearly as possible. Today there is a strong case for cutting interest rates; how big the first cut should be is less clear A common argument earlier this year was that the Fed had a “no go zone” around the election. However, that would be a big mistake when economic fundamentals argue for action. ?

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Economics: Market pricing does not determine Fed policy

In my experience, there is a tendency for participants in the bond market to overestimate the impact of market pricing on actual Fed decisions. Yes, the markets usually move ahead of the Fed (Exhibit). However, this doesn’t mean markets move the Fed, but that the market understands the Fed, responding to data and guidance in real time. It is consistent with the notion of “gradualism” where the Fed does not immediately move to its target rate, but instead moves in small increments while communicating to the markets the direction of travel.

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The Fed does not want to get in the business of placating the bond market. In the extreme, if market pricing fully determines the next Fed move, then the policy path will becomes completely unanchored—in technical terms, there will be a sunspot equilibrium. ?Even if the market pricing has a modest impact on the Fed decisions it will make the funds path less stable. The Fed needs to be particularly careful in chasing its tail today, with market pricing moving back and forth between 25 and 50 bp.

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This does not mean market pricing is completely irrelevant. FOMC members are well aware of what the markets are expecting. And they want expectations to be roughly consistent with their own projections. The bottom-line is that market pricing has a very small, episodic impact on the Fed's policy path.

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Surprises are the norm?

What does this mean for this week’s decision? If the Fed cuts only 25 bp, it could disappoint the bond market and could cause a (small) tightening of financial conditions. Wouldn’t that undercut their shift to supporting the economy? Won’t the Fed want to cut 50 bp to add further stimulus into the market?

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Let’s look at what happens in the bond market when the Fed is on the march. In particular, let’s look at how 2-year yields moved on Fed decision days during the last cycle—the tightening cycle from March 2022 to July 2023. Over those 12 meetings the Fed hiked 25 bp five times, 50 bp two times, 75 bp four times, and skipped hiking at one meeting. Did the market tend to move in the Fed’s favor on decision days, adding upward pressure on two-year yields?

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While this is a small sample, it is striking that the bond market tended to move in the “wrong” direction in response to FOMC announcements (Exhibit). The market rallied on seven of these twelve meetings, with an average 4.7 bp drop in the two-year yield. Even more striking is that this occurred during a period of steadily rising rates: the 2-year yield rose from about 2% to almost 5% over this period.

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Some of these counter-cyclical moves were big and warrant some explanation:

·????? June 15, 2022—a 25 bp rally at the short end. This occurred even though this was the first mega hike of 75 bp since 2000. Apparently the markets were worried about an even bigger hike (?).

·????? February 1, 2023—a 12 bp rally at the short end. This seems to be because the markets viewed the Fed’s hike of only 25 bp as signaling the hiking cycle was almost over.

·????? March 22, 2023—a 21 bp rally at the short end. This seems to be related to the fact that the Fed went ahead and hiked 25 bp despite banking stress.

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Regardless of the individual episodes, clearly the Fed was not particularly focused on getting the market to move in the “right” direction on decision days. Indeed, I came away from this exercise surprised at how out-of-sync the Fed and markets were on these game days. Yes, they want the short end of the treasury market to support the direction of policy over time—hence the big cycles in two-year yields shown the first exhibit. However, on game days the focus on getting the Committee to a consensus.

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My guess is that the Fed cuts 25 bp, Powell suggests that this is just the start of a cycle of cuts and the dot plot moves to a string of 25 bp cuts, including two more this year. Alternatively, they cut by 50 bp and Powell tap dances around why this may not be repeated. Fasten your seatbelt.

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