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Why markets are looking for clues on an 'insurance cut' from the Fed

Brian Cheung

Could the Federal Reserve provide clues on whether or not a rate cut is in its crystal ball for 2019?

That’s a question that market participants and Fed watchers are asking ahead of this Wednesday’s Federal Open Market Committee (FOMC). In the FOMC’s last meeting in March, policymakers signaled no rate hikes for 2019, spurring chatter about whether or not the next move would be to cut the benchmark interest rate.

As of Monday morning, fed funds futures were pricing in a 47.7% chance that policymakers cut by at least 25 basis points by the end of its September 18 meeting. Some are arguing for the Fed to make an “insurance cut” to get ahead of a possible recession.

Chicago Fed President Charles Evans told The Wall Street Journal April 22 that he could support that insurance if inflation readings came in low. He elaborated that the Fed, which has consistently undershot its 2% inflation target, may be pushing “restrictive” monetary policy if measures of core personal consumption expenditures start coming in around 1.5%.

“Anything that’s sustainable, that looks like it’s moving downward, not upward, I would be extremely nervous about,” Evans said. “And I would definitely be thinking about taking out insurance in that regard.”

In the most recent reading of core PCE - the Fed’s preferred measure of inflation which strips out food and energy - had prices increasing by only 1.6% year-over-year in March.

JPMorgan Chase’s Michael Feroli wrote April 26 that this meeting could see the first dissent under Chairman Jerome Powell, possibly from St. Louis Fed President James Bullard. Feroli said he could see the committee focusing on muted inflation pressures.

“The only feasible candidate to dissent is Bullard; while not our baseline it wouldn’t be too surprising if he voted to cut rates,” Feroli said.

Bullard told Yahoo Finance April 17 that he is pleased with the Fed’s “flat rate outlook” given the lack of inflationary pressures.

James Bullard, president and chief executive officer of the Federal Reserve Bank of St. Louis. Photographer: Akio Kon/Bloomberg via Getty Images

1997 all over again?

Analysts are zoning in on inflation to see if the Fed’s next move will be a rate cut.

Evans and Vice Chairman Richard Clarida have referenced the 1997-1998 stretch where the Fed pivoted from raising rates to a “wait-and-see” policy approach while the Asian financial crisis was heating up.

In 1998, the Fed cut rates by 75 basis points amid the Russian default. The Fed characterized that first cut as “insurance against the risk of a further worsening in financial conditions.”

Earlier this month, Clarida acknowledged the Fed’s history with “insurance cuts” on CNBC but said committee members “certainly don’t see a recession right now.”

February survey from the National Association of Business Economics had 10% of economists predicting a recession in 2019 and 42% of economists predicting a recession in 2020.

Powell is likely to field questions about the possibility of an insurance cut in the meeting.

In a note April 26, TD Securities wrote that Powell will likely insist that inflation will gradually rise to its target over the next year or two, but said the chairman would be open to data that says otherwise.

“It would take both a sizable (to 1.5% or lower) and persistent (likely three months or more) drop in core PCE inflation to get the Fed to start to seriously discuss cutting rates.”

Barclays agreed that for the time being the Fed does not need to seriously consider a cut, pointing to the GDP report for the first quarter showing the U.S. economy growing by 3.2%.

“In our view, the Q1 GDP report and other components of the March data flow are likely to leave the Fed feeling that the outlook has improved somewhat since the committee last met.”

The May FOMC meeting will conclude at 2:00 p.m. ET on Wednesday, May 1.