MNI PREVIEW: Fed On Hold But Downside Risks Test Patience

By Jean Yung

     WASHINGTON (MNI) - Federal Reserve officials are likely to keep policy on

hold at this week's much-anticipated FOMC meeting, as they debate the timing for

lowering interest rates should the outlook worsen in line with deteriorating

market measures of recession risk.

     Policymakers are in a delicate situation, caught between disappointing but

not disastrous U.S. macro readings and overwhelming expectations of rate cuts

this summer. Weak inflation data and heightened trade tensions have raised

downside risks in recent weeks. But officials have also stressed the need to see

the situation play out before committing to a path of easing.

     Softer U.S. macro data do not present a clear case for an imminent interest

rate cut, senior Fed economists told MNI this month. The Atlanta Fed's latest

GDPNow forecast for the second quarter reads 2.1% after Friday's upbeat retail

sales and industrial production reports. The economy was widely expected to lose

momentum this year after a fiscal stimulus-fueled growth spurt and that may be

exactly what is taking place.

     On the other hand, President Donald Trump's announcements of higher tariffs

on Chinese imports and threatened levies on Mexican goods caught markets by

surprise and intensified business uncertainty -- with negative implications for

growth.

     --PATIENT GUIDANCE

     Fed Chair Jay Powell's vow this month to act "as appropriate" to sustain

the expansion suggests the Fed may be ready to scrap guidance that it will be

"patient" in determining the next rate move and instead try to convey the

conditions under which it would lower rates.

     Vice Chair Rich Clarida indicated May 31 that the FOMC would take take into

account a "persistent shortfall in inflation" or material downside risks from

"global economic and financial developments."

     CPI missed expectations in May but the Fed's preferred measure of consumer

inflation, the personal consumption expenditure price index, so far remains

steady, though muted, at 1.5% overall and 1.4% for items excluding food and

energy. The post-meeting statement may acknowledge a downward move in inflation

expectations, a worrisome development for officials as they prepare to debate

its inflation targeting framework.

     If tariffs drive up inflation by several tenths over the span of a few

months this year, the Fed may look through those developments. But policymakers

will stay vigilant on their impact on growth and business sentiment.

     --INSURANCE CUTS

     It would only take two officials to revise down their projected paths for

policy for the median projection for 2020 to fall from 2.6% to 2.4%, matching

this year's median.

     Some officials may also project rate cuts this year after taking account of

elevated downside risks. Taking out so-called insurance rate cuts lowers the

probability that the economy weakens in the months ahead by offering more

stimulus upfront. If the outlook improves, the cuts could be reversed later.

     Meanwhile, market measures of risk are flashing red. Morgan Stanley said

its US Business Conditions Index collapsed in June to the lowest level since

December 2008. The New York Fed's Probability of Recession Indicator, based on

Treasury Spreads, has risen to levels which have been followed by a recession in

8 of the last 9 occurrences, only giving one false signal since 1960.

     But there are potential costs to such an easing move which the FOMC will be

sure to debate. If the Fed is perceived as responding to fears of what could

happen rather than what is in the data, it may find itself beholden to market

anxieties on a regular basis.

     That is a risk that might be harder to unwind.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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