The Fed May Surprise Wall Street and Shun Cuts in Interest Rates

It’s risk on again for many investors as they scoop up stocks on bets the Federal Reserve will cut interest rates before the year is out, but there are some on Wall Street that are not so convinced. Economists at Goldman Sachs think the Fed will hold off on interest rate cuts for at least the next two years, a view that runs contrary to what markets are currently predicting. 

“Our economists’ base case forecast is the Fed does not cut interest rates during the next 2 years, but the team views mounting trade tensions as a source of downside risk that is likely to get worse before it gets better,” says Goldman in last week’s version of their Weekly Kickstart report. 

Recent weakness in manufacturing and jobs data, not to mention Fed Chairman Jerome Powell’s comments last week that the Fed would act as necessary to maintain the current expansion, has investors increasingly convinced that rates will soon be cut. Futures markets have now priced in a 90% likelihood of a rate cut of at least 25 basis points (bps) by the end of 2019.

Professional forecasters, however, have a different opinion. Citing FactSet data, Goldman notes that over the past two weeks, 30 professional forecasters have either revised or reconfirmed their predictions for the federal funds rate. The median forecaster among them expects that rate to be unchanged by the end of the year, and only 13 expect some degree of monetary easing. 

While Goldman’s economists don’t expect rate cuts for the next two years, they do think that the Fed will tread carefully as it attempts to bring investor expectations back in line with their policy goals. “If the Fed does not intend to ease policy this year, history suggest it is likely to gradually walk back market expectations for easing in coming months rather than deliver a hawkish disappointment,” the firm’s analysts said. 

Expectations aside, one reason the Fed may choose not to raise rates is to assert its independence by showing that it won’t easily be pulled into President Trump’s trade battles and demands for lower rates. While Powell’s comments last week helped to soften the blow of Trump’s escalating trade war, he likely wants to avoid actually cutting rates so as not to look like he’s supporting the economy in order to allow Trump to continue fighting his battles, according to a Wall Street Journal column.

Central banking is as much about political maneuvering as it is about technical maneuvering, despite central bankers’ desire to convince markets that it is mostly technical. Unfortunately, the desire to maintain an air of independence could cause the Fed to hold off on rate cuts longer than it should.

Of course, if the wisdom of crowds prevails and the Fed decides to cut rates in line with market expectations, equities could receive a major boost. Goldman looked at the past 35 years and found that following the start of 7 Fed rate cutting cycles, or after the first interest rate cut during a trailing 12-month period, the median rise of the S&P 500 over the next 3- and 12-month periods were 2% and 14%, respectively. But you don’t have to tell investors that lower rates are good for stocks, as their rush back into the market over the past week reveals.