Fed Hopes Lower Rates Spark Higher Inflation

    Facebook Twitter LinkedIn Email

By John Lovito and Charles Tan - July 31, 2019

The Federal Reserve (Fed) has cut short-term interest rates for the first time in more than 10 years. In a widely anticipated move, the central bank reduced the federal funds rate target 25 basis points, to a range of 2.00% to 2.25%. The Fed cited global influences on the U.S. economic growth outlook and muted inflation pressures as reasons for the cut.

Policymakers also announced they would end their balance sheet reduction efforts August 1, two months earlier than planned.

The Fed noted in its post-policy-meeting statement  it expects the economic expansion to continue and inflation to rise. However, the statement also hinted additional rate cuts may be necessary to achieve those goals, given “uncertainties” about the economic outlook.

In remarks following the meeting, Fed Chair Jerome Powell discounted expectations for an extended easing cycle. The stock market viewed Powell’s comments as more-hawkish than anticipated, and U.S. equities sold off. The U.S. yield curve flattened, with the very short end selling off and the intermediate through the long end rallying in hopes of future rate cuts.

Upbeat Economy Masks Fed’s Concerns

The Fed’s first easing since 2008 comes as the U.S. economy appears relatively healthy. As expected, second-quarter growth slowed from 3.1% (annualized) in the first quarter to 2.1% in the second quarter. But, fueled by robust consumer spending, the second-quarter growth rate beat market expectations. Additionally, the jobs market remains strong, driving the unemployment rate to a 50-year low.

Nevertheless, the Fed is concerned about other data. Specifically, inflation remains subdued and well below the central bank’s targets. Year-over year core inflation (minus food and energy prices) stands at 1.6%, below the Fed’s 2.0% goal. Longer-term inflation expectations have dropped considerably and remain lower than historical averages.

Powell recently said he worries about an “unhealthy dynamic” if inflation remains too low for too long. The Fed chair noted, “lower expected inflation gets baked into interest rates, which means lower interest rates, which means less room for the central bank to react” to economic downturns.

In addition, market interest rates are unusually low, a notable anomaly in this extended period of job gains and economic growth. Furthermore, the yield curve between three months and 10 years has been inverted for several months, meaning shorter-maturity rates are higher than longer-maturity rates. This irregularity suggests Fed monetary policy is too tight.

Cut Provides Cushion Against Slowing Growth

The ongoing U.S.-China trade conflict continues to cloud the global economic outlook. Amid these continuing tensions, today’s rate cut provides a cushion for U.S. economic growth and inflation.

Given the interdependence of the U.S. and other developed market economies, we don't believe U.S. market rates, which are already notably higher than in other markets, can rise much more. Rates in other developed markets are unusually low and even negative in some places, which is helping to keep a lid on U.S. rates.

Furthermore, the European Central Bank is considering additional central bank stimulus measures, including cutting rates deeper into negative territory, to combat weak growth and inflation. These efforts likely will put additional downward pressure on U.S. rates.

A Fine-Tuning of Monetary Policy

With the U.S. economy still growing at a healthy pace and faster than its peers, we don’t believe today’s rate cut represents the start of a major easing cycle. Instead, we view it as the Fed recalibrating its monetary policy amid slowing, though still positive, economic growth and muted inflation. In retrospect, the Fed’s last rate hike in December 2018 likely was one rate hike too many.

In our view, two rate cuts, or a total 50 basis points of easing, over the next 12 to 18 months should be sufficient to lift inflation expectations, steepen the yield curve and support continued economic growth. We believe market expectations for three to four Fed rate cuts, or 75 basis points to 100 basis points of total easing, are unlikely.

Investment Outlook Unchanged

Investors generally expected the Fed to cut rates at its July monetary policy meeting, and asset prices already reflect a more-dovish Fed. Therefore, we don’t expect a significant reaction from the financial markets. However, down the road, if Fed actions deviate from market expectations, stocks and other risk assets may suffer.

Our outlook for the economy and fixed-income market remains unchanged. A dovish Fed and lower interest rates likely will keep the U.S. economy growing at a relatively healthy pace. However, trade-policy uncertainty continues to present one of the greatest downside risks to U.S. and global economic growth. Taking these factors into consideration, we expect the U.S. economy to maintain trend levels of growth (2.0% to 2.5%).

In the near term, we also believe inflation likely will stay well below the Fed’s targets and interest rates will remain relatively low. Over time, we expect Fed policy and modest economic growth to push inflation and interest rates moderately higher.

Because we’re in the late stages of the current economic cycle, we’re maintaining a prudent approach toward bond market risk. We believe short-term volatility will stay elevated as investors remain fixated on central bank policy. We also believe the importance of active management becomes even more apparent during volatile periods, given the investment opportunities that often emerge.

In the near term, we believe the dovish Fed and stable economic growth still support most fixed-income sectors. From a longer-term, strategic perspective, we plan to continue to reduce exposure to riskier bond market sectors, given the potential for price weakness as the credit cycle matures.

Source: FOMC Statement, July 2019

    Facebook Twitter LinkedIn Email

Insights From Our CIOs

Get additional insights in our latest Investment Outlook.

Discover More
  • Related Articles
  • More From Author

Mid Cap Growth Impact ETF: 2021 Impact Report

We will continue to seek and invest in innovative, disruptive companies that challenge the status quo, drive industry change and help lead us to a brighter future.

Sustainable Equity Fund Sustainability Report

See how we have integrated ESG analysis alongside traditional financial evaluation to identify sustainable companies that offer the potential to deliver excess returns over time.

Market Minute

Our Investment Teams discuss key topics for today's markets.

    Global Fixed Income

    Providing a concise, easy-to-scan overview of current opportunities and risks in today's global markets.

    The Downside of Negative Interest Rates

    Negative-yielding debt has been steadily increasing throughout the world, and many investors worry the U.S. won’t remain immune from this bond market anomaly. Co-CIO Charles Tan shares why negative rates could present significant risks.

    Fed Tackles Mounting Inflation With Belated Rate Hike

    Rising rates, volatility emphasize the need for portfolio diversification, downside protection.

      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

      American Century Investments is not responsible for and does not endorse any comments, content, advertising, products, advice, opinions, recommendations or other materials on or available directly or via hyperlinks to third party applications or websites. Logos or icons used are registered trademarks of their respective owners.