For the FOMC, “uncertainties” now dominate
At the June meeting, the FOMC’s stance on monetary policy shifted materially. While their core view of the economy remains positive, “uncertainties” now dominate.
Beginning with the core view, it clearly remains constructive. The only real economy forecast to see material revision in June was the 2019 inflation view, which was revised down from 1.8% to 1.5%.
Arguably this revision is a consequence of (purportedly transitory) weakness in PCE inflation since the March meeting rather than fears over its future path. Supporting this view, core inflation is seen at 1.8% in 2019 (previously 2.0%) then 1.9% and 2.0% in 2020 and 2021 respectively.
There was also essentially no change in the GDP forecasts, with above-trend growth still seen across the forecast horizon. The unemployment rate forecasts meanwhile were actually marked a touch lower.
Despite these economic forecasts, that seven participants now see two cuts in the federal funds rate by year end, and another member one cut, highlights that risks are now front of mind.
Of the risks, US trade tensions with China (and others) and, more broadly, anxiety over global growth are the focus. The meeting between President Xi and President Trump at the Osaka G20 in a little over a week will therefore be crucial.
The above begs the question, why not cut now? As made clear in the press conference by Chair Powell, the reason is that the Committee want to respond to trends that are sustained, not just temporary noise.
To the extent that trade tensions have really only escalated (again) in the past month, the FOMC clearly want to gain a greater understanding of their persistence as well as the potential consequences for the US economy.
In our recent analysis of the US economy, we highlighted that, assuming trade tensions did not escalate further but uncertainty remained, business investment was likely to deteriorate. Further, we noted that employment could also be affected by current tensions.
Under said scenario, we felt a pro-active but measured approach to policy was warranted, cutting twice by year end – most likely in September and December.
From June’s communications, it seems that the FOMC are broadly aligned to this view. Very clearly though, there are considerable risks, most notably of quicker policy action.
After the Osaka G20 meeting, President Trump may well extend the 25% tariff to the remaining $300bn of US imports from China or continue to threaten to do so in the near future if he does not get his way.
Given the soft state of US investment and fragile confidence amongst business, under either scenario, the FOMC could easily justify bringing forward the first cut to July and show stronger concern over the outlook.
To see the FOMC deliver more than two cuts over the coming year however, consumption would have to weaken along with investment. While not our base view, given the surprisingly weak employment outcome of May and as wages growth now looks to be turning down, this is a risk worth watching.
Upside risks to the outlook carry a much lower probability. The one to call out is clear evidence of a resolution to US/ China tensions at the Osaka meeting. Should this occur, then near-term rate cuts would be put off.
That said, based on his actions of the past year, it seems highly unlikely that President Trump will abandon his trade agenda all together ahead of the 2020 Presidential election. Hence an easing bias would still be warranted for fear that trade tensions would emerge again.
Implications for the Australian dollar
One of the primary determinants of the Australian dollar’s value is the interest rate differential between Australia and the US. As such, the actions of the FOMC and the market’s forward expectations matter a great deal for our currency.
Since the RBA cut the cash rate on 4 June, the Australian dollar has fallen almost a cent to around USD0.69 currently. This came as the expected terminal cash rate for this cycle fell further and faster than occurred in the US for the federal funds rate.
In our view, as expectations for the RBA prove correct (two cuts by year end) but the market is disappointed by the FOMC (two cuts rather than the three the market currently sees by end-2019), the Australian dollar should continue to fall, most likely to around USD0.68 in the second half of the year.
If as we expect, two cuts from the FOMC in 2019 stabilises growth into 2020 while Australia remains weak, then a further leg lower in the Australian dollar will be seen to around USD0.66 in the first half of 2020.
In terms of the risks to this view, given the weak state of our consumer, domestic risks are against Australia. Negative global shocks are also likely to lower our currency against the US dollar given the US dollar’s safe-haven status.
To the upside however, there is of course commodity prices which remain a significant source of strength for our currency.
In recent weeks, the price of iron ore has continued to strengthen to around USD117 currently. In Australian dollar terms, that puts the commodity at a record high price, circa AUD170.
While we anticipate prices will fall to end-2020 as Brazilian supply comes back on line, progress here will be slow. As a result, the downside skew for risks notwithstanding, there is a chance the Australian dollar continues to outperform in the near term.