September 17, 2019 / 5:06 AM / a month ago

Divided Fed set to cut interest rates this week, but then what?

SAN FRANCISCO (Reuters) - Deep disagreements within the Federal Reserve over the economic outlook and how the U.S. central bank should respond will not stop policymakers from cutting interest rates at a two-day meeting that began on Tuesday.

FILE PHOTO: Federal Reserve Board Chairman Jerome Powell testifies before a Senate Banking, Housing and Urban Affairs Committee hearing on the "Semiannual Monetary Policy Report to Congress" on Capitol Hill in Washington DC, U.S., July 11, 2019. REUTERS/Leah Millis/File Photo

An oil price spike after attacks on Saudi Arabian oil facilities over the weekend added to the list of risks facing an economy already slowed by ongoing trade tensions and global weakness.

But the deep divide evident around the Fed’s policymaking table means further rate cuts could be far from a done deal, and on Tuesday traders were no longer betting the central bank will follow Wednesday’s expected rate cut with another by the end of the year.

At one end of the Fed’s large boardroom table sit St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari, who are expected to argue for a steep reduction in borrowing costs to counter low inflation and an inverted Treasury yield curve.

Pushback from the opposite end is likely to come from Cleveland Fed President Loretta Mester, who opposed the Fed’s rate cut in July, and Philadelphia Fed President Patrick Harker, who only reluctantly supported it and says he wants to leave rates where they are “to see how things play out.”

Fed Chair Jerome Powell, seated midway down the table, faces the delicate task of taking on board those views and the disparate arguments of the other dozen policymakers to build consensus.

A top challenge: making sense of economic data that suggests the U.S. manufacturing industry may be contracting and inflation remains weak, even as households continue to spend and employers overall are adding plenty of jobs.

“The discord is extremely visible,” said Gregory Daco, chief U.S. economist at Oxford Economics. “If you look at the economy today, you look at an economy that’s bifurcated ... The key question is whether that weakness seeps through the economy, and whether that’s aggravated.”

On Tuesday, uncertainty over the rates outlook made its way into the market for interest-rate futures tied to the Fed’s policy rate, where bets rose that the central bank’s expected reduction to its benchmark overnight lending rate this week will be its final rate cut of the year.

Traders, as of late Tuesday morning, gave a 61% probability that the Fed would reduce its policy rate by a quarter of a percentage point to a range of 1.75% to 2% on Wednesday, down from 92% just a week ago.

Further complicating matters, the Fed’s policy rate spiked overnight, forcing the New York Fed to take immediate steps to relieve stress in U.S. funding markets that are relied on by securities firms to finance their positions.

Though the volatility isn’t expected to have a direct impact on the Fed’s setting of rates, it could weigh on Fed officials as they consider technical adjustments and guidance for their balance sheet outlook.

‘MIXED OPINION’

Since the Fed’s 8-2 decision to cut rates in July, a move that Powell called a ‘mid-cycle’ adjustment, the economic data has delivered mixed signals.

Strong retail sales and continued wage growth may add to Boston Fed President Eric Rosengren’s confidence that current economic conditions do not justify further policy easing. He dissented in the July policy decision.

The ongoing U.S.-China trade war makes Dallas Fed President Robert Kaplan among others concerned about slowing factory output and a slide in business investment. Kaplan supported July’s rate cut.

The newest wild card to factor in to the debate emerged unexpectedly in Saturday’s attacks on the Saudi oil facilities, which triggered the biggest spike in oil prices in more than two decades.

Fed officials could see the development either as a risk to an already fragile growth outlook, which would support the case for more easing, or as a welcome boost to inflation, which would back a case for standing still for now.

“If everyone was on the same page at the Fed I could understand it,” said Lee Ferridge, head of macro strategy for North America at State Street Global Markets.

“But clearly there is disagreement at the Fed ... If the Fed is very split and Powell can’t give a strong signal, doesn’t that imply very few moves are likely, rather than these dramatic cuts?”

Fed policymakers will bring to the meeting their own views of where rates should be by December. In June, the last time they published their forecasts, about half of policymakers expected a total of two rate cuts this year; about half thought no rate cuts would be appropriate.

That divide in the so-called Fed “dot plot” has borne little relation to how policy has actually shaped up, but it could add to confusion over the rate outlook after the conclusion of this week’s meeting.

With more dovish policymakers like Bullard, Kashkari and Chicago Fed President Charles Evans calling for more easing, and more hawkish policymakers like Mester, Harker and Kansas City Fed President Esther George more skeptical, “expect the 2019 dots to reflect this mixed opinion,” said Jefferies economist Ward McCarthy.

Reporting by Ann Saphir; Editing by Dan Burns and Paul Simao

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