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The lack of progress in trade talks between the U.S. and China underlies why the Fed would take the unusual step of cutting interest rates in an economy that seems to be on solid footing.
The Federal Open Market Committee, at the end of its two-day meeting Wednesday afternoon, is widely expected to announce a quarter-point rate cut, its first since it took interest rates to zero during the financial crisis in December 2008. It is also expected to leave the door open to further rate cuts, and many market pros expect it to announce an early end to its quantitative tightening program, under which it was shrinking its $3.8 trillion balance sheet.
Rarely has the Fed cut rates before the economy looked set to spiral downward, but Fed chair Jerome Powell has cited trade uncertainties and a slowing global economy as reasons to switch to accommodative policy, at a time when inflation is also low.
U.S. and Chinese trade negotiators ended their meetings this week, with no signs of new progress. Chinese state media said talks will resume in September, extending any possible deal by months. As the talks were underway this week, President Donald Trump fired off a series of tweets criticizing China's trade practices, claiming that it was not making the purchases of U.S. agricultural products it promised to buy.
"If anything, the lack of progress in the Shanghai meetings confirms the Fed's decision to move forward with preventative rate cuts, as these uncertainties are sure to linger in the market well into the fall," said Ian Lyngen, head of rate strategy at BMO. "I think uncertainty is leading to lower business confidence, particularly on the manufacturing side in the U.S., and perhaps on the production side in China, there's more pressure from the trade war."
Some market pros expect a 50 basis point rate cut, but the fed funds futures market puts the probability of a quarter-point cut at more than 78% and a half-point cut at around 22%, according to the CME Fed Watch Tool.
"What the Fed is doing is unprecedented. There's no historical precedent. ... There's no example that with still above trend growth and still above trend labor growth has the Fed eased in the middle of an expansion," said Ethan Harris, head of global economic research at Bank of America Merrill Lynch. "This is a six sigma event. If there were more clear evidence that the trade war was hurting, this would only be a small departure from normal but actually the data in the last month has improved."
Powell has made it clear the Fed is willing to make an "insurance cut" to protect the economic expansion, the longest on record as of this month.
Even as the central bank has moved toward cutting rates, Trump continues to criticize the Federal Reserve and Powell. Trump says the Fed should have cut interest rates and its policy has hurt the U.S. economy.
On the eve of the Fed's decision, Trump said Tuesday the Fed should make a big interest rate cut. "I'd like to see a large cut, and I'd like to see quantitative tightening immediately stopped," Trump said, commenting on the Fed's efforts to reduce the bonds it is holding on its $3.85 trillion balance sheet.
"They moved in my opinion far too early and far too severely, and puts me at somewhat of a disadvantage," the president added. Some economists expect the Fed to end the roll-down of its balance sheet early, but the program was already expected to end in September.
"This is a high-wire act. When it comes to communications, that is the hardest part. They want to do more, but they don't know when and how much further they want to go, including on the balance sheet," said Diane Swonk, chief economist at Grant Thornton. Swonk said the Fed still has to decide what type of securities it wants to use to replace maturing securities on the balance sheet, meaning more short-term or long-term Treasurys.
Many strategists do not believe the Fed's move to cut rates is a response to the president. "I think it's complicating their lives because I think they don't' want to be seen as caving to the White House," said Scott Minerd, co-founder and global CIO of Guggenheim. "At the same time, they want to cut rates and every time Trump talks about how they should be cutting rates, it makes their life more difficult."
Minerd said the only way that Fed policymakers are reacting to Trump is indirectly in that they are hoping to fend off the ill effects of his trade war with China. The trade war has impacted mostly manufacturing data, dragging down exports and impacting inventories. Economists say that so far, the consumer has been largely untouched by trade concerns and both consumer confidence and consumer spending are strong.
While many economists and strategists believe the Fed will cut rates, not everyone agrees it should in the face of stronger data — and that includes some members of the Fed. One of them, Boston Fed President Eric Rosengren, said on CNBC recently that he did not see a reason to cut rates now, given the economy is strong and inflation is nearing the Fed's 2% target.
"They're going to get at least one dissent," said Swonk. "I think that is healthy to have a dissent right now because I think that also asserts the independence of the Fed. ... The critical issue is perception versus reality. If people perceive the Fed as capitulating, that hurts their credibility."
Trump has also said the dollar is too weak and blamed the easy policies of other central banks, for weakening their currencies. The strong dollar could in fact become a worry for the Fed.
"When you look at it what the [European Central Bank] is doing and every other central bank, ... if you think about it in terms of the dollar and if the Fed doesn't respond, the dollar is going to go up in value, and a strong dollar is disinflationary," said Jim Caron, Morgan Stanley Investment Management portfolio manager. "If the Fed doesn't go, it will miss its inflation target."
Caron said he expects the Fed to trim by 50 basis points. "I know it's ... nonconsensus, but all I really am trying to say is keep an open mind for the fact that 50 is logical and, obviously the smart money thinks that they're going to do 25. That's what's pricing in to the market," said Caron. "If they don't do 50 in July, they're going to do 25 in September so by October, they'll be at 50."
But Stephen Stanley, chief economist at Amherst Pierpont, expects the Fed to make one quarter-point rate cut and then stop.
"I think they want to keep their options open." he said. "I don't think they want to disappoint the markets but at the same time, I don't think they want to feed the beast anymore than they have to. I think the economy is holding up better than it was in June."
Some economists believe the Fed has limited firepower with the fed funds target range at just 2.25 to 2.50, and for that reason it should move ahead to prevent the economy from weakening. On the other hand, there is a concern that if the Fed uses its limited ammunition now, while the economy is still strong, it would be powerless later on if the economy turns bad.
"The data don't really support a move. Certainly, the data shows the economy is growing at 2.5% in the first half of the year. There's at least some evidence that core inflation ... after a brief dip in the first half does seem like it's coming back to a 2% trend," said Stanley. "I think the inflation number doesn't quite have the urgency we may have feared a month or two ago."
The Fed targets inflation at 2%, and the number it follows, the core PCE deflator inflation gauge the Fed watches, was at 1.6% in June.
Minerd said the Fed risks stoking bubbles in asset prices by cutting rates in an environment where the economy is solid. However, he believes the Fed should cut interest rates and then go back to basing its decision on its more traditional metric — the economic data.
"I would argue they should go ahead and cut rates. They should hem in the expectation for more rate cuts. I think they should say 'we will adjust policy appropriately,'" he said. "Future policy actions will be driven based upon data dependency which is consistent with what they always did. I would definitely advertise this as an insurance rate cut. It's clearly not supportable based upon the data. This is completely anticipatory based upon uncertainties around the trade war, slowing growth in Europe. They're attempting to get ahead of it. ... They are going for broke."