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Why the Fed's next move could be a rate cut

Javier E. David
Editor focused on markets and the economy

The Federal Reserve’s interest rate hikes — something market observers and President Donald Trump once widely characterized as a policy error — may become the central bank’s saving grace in the face of a slowing global economy.

On Wednesday, the Fed held its benchmark rate steady at 2.25-2.50%, after a tightening campaign meted out four hikes in 2018.

Yet with the U.S., China and Europe all showing signs of decelerating growth, the central bank now finds itself with more room to maneuver than its counterparts in other major economies, which are still in crisis mode with monetary policy.

Room to cut amid slowing growth

The irony is the Fed’s determination last year to get ahead of inflationary pressures has created a scenario in which the central bank now has room to be accommodative, if the global economy’s soft patch becomes an outright ditch.

By contrast, the European Central Bank has benchmark rates near zero and negative bank lending rates, meaning there’s almost no room to respond if the downturn deepens.

Most economists expect the global economy to escape the tendrils of a full blown recession. Still, a small but vocal minority think the current downturn could become something more severe, especially with the U.S.-China trade war still up in the air.

“The Fed’s revised economic projections, which now imply no rate hikes this year, may have been a bit more dovish than most anticipated, but we think their underlying economic forecasts are still too upbeat,” Capital Economics’ Michael Pearce wrote in the aftermath of the Fed’s Open Market Committee (FOMC) decision.

“We expect economic growth to remain well below trend throughout 2019 which is why we think the Fed’s next move will be to cut interest rates,” Pearce said, adding that it expects rate cuts of at least 75 basis points (¾ of a percentage point) by the first half of next year.

Earlier this week, RSM chief economist Joe Brusuelas wrote that weaker data and falling price pressures led him to the conclusion that the Fed will ultimately have to cut rates “should the clearly visible downturn in overall economic activity over the past four months not reverse course.”

“For the Fed to hike, it takes growth”

Those sober assessments echoed the sentiments of Andrew Schneider, BNP Paribas’s senior US economist, who said last week that the Fed’s “next move is likely to be an easing” rather than a rate cut.

“For the Fed to hike, it takes growth,” Schneider said, something that was unlikely given slowing consumer spending and job growth.

The Fed’s current dilemma is a far cry from several months ago, when a steady increase in borrowing costs upset markets and infuriated the president. In fact, Trump reportedly weighed firing Fed Chairman Jerome Powell just before Christmas, a threat serious enough for Powell himself to openly state he wouldn’t step down if asked to by the man who appointed him.

Since the Fed last hiked rates in December, the outlook has taken a turn for the worse. U.S. economic and jobs growth has slowed down sharply, as has consumer spending.

Embroiled in a trade dispute that shows no signs of a quick resolution, China is also in the throes of slower growth. In January, the world’s second largest economy reported that growth swooned to its lowest in nearly 3 decades, and could be hurt even more if Trump and Chinese President Xi Jingping are unable to strike a deal to end the trade war and lift tariffs.

In late trading, The S&P 500 (^GSPC) and the Dow (^DJI) fell in reaction to the Fed’s dovish view on interest rates.

—Yahoo Finance’s Brian Cheung contributed to this article.

Javier David is an editor for Yahoo Finance. Read more:

Follow Javier on Twitter: @TeflonGeek