As Fed Pauses on Interest Rates, Some Economists Now Project Cuts

The Federal Reserve's recent decision to hold U.S. interest rates steady after a three-year campaign of raising them came so swiftly that economists at Bank of America Corp. (BAC - Get Report) described the shift as a "90-degree turn."

But with President Donald Trump's economy showing signs of slowing, some Wall Street analysts are now predicting that the Fed's change of course may end up looking more like a U-turn.

Minutes from the Fed's January meeting, scheduled for release on Wednesday, Feb. 20, could show the extent to which officials discussed terminating or modifying a plan to reduce the central bank's roughly $4 trillion balance sheet, which more than quadrupled in size during the financial crisis as officials took emergency steps to revive markets with piles of freshly minted money.

And at least one top economist now predicts that the central bank, led by Chairman Jerome Powell, may even consider cutting interest rates by September - the first such move since the aftermath of the crisis.

With inflation subdued at around 2%, there's no incentive for the Fed to raise rates this year, especially since doing so would likely cause the economy to slow further, said Steve Blitz, chief U.S. economist at the forecasting firm TS Lombard. 

Futures markets imply zero odds of further rate increases by October, currently set in a range between 2.25% and 2.5%. As recently as October, the chances of two further quarter-percentage-point increases stood at nearly 40%.

The reason the Fed might need to act sooner rather than later to stimulate the economy? Growth is projected to slow this year to 2.5% this year from about 2.9% in 2018, hampered by market volatility, fears of a trade war with China and the fading stimulus from Trump's late-2017 tax cuts, to say nothing of the higher borrowing costs.

And because of the fresh memories of the financial crisis, the Fed may need to move quickly to keep the economy from getting anywhere close to stalling, Blitz said in an interview. According to a Feb. 15 report by the German lender Deutsche Bank, many investors already see "downside risk."  

"They would rather be preemptive and act a little bit sooner," Blitz said. "If there's no inflation, and there's no pressure on inflation, where is the rationale to raise rates and create a slowdown?"

Trump has repeatedly criticized Powell - his own appointee to lead the central bank - for raising interest rates too quickly, and most investors agree that a quarter-point rate increase by the Fed in December helped to drive a late-2018 stock-market rout.

Stock markets have rebounded this year, but signals from the bond market show that the U.S. economy may still be in danger of tipping into recession. The difference between yields on 10-year and two-year Treasury notes is less than 0.2 percentage point; typically, the gap is much higher and history has shown that when the figure turns negative or "inverts," a recession is likely.

Last week, Deutsche Bank economists delayed their expectations for future rate increases, saying that the Fed is likely to raise rates only once this year, by a quarter percentage point, leaving only one more hike in store in 2020. 

According to the bank's report, the "downgrade" came largely because of a perceived softening in the economy, due to the lingering impact of Trump's longest-in-history U.S. government shutdown, which delayed paychecks for hundreds of thousands of government workers and may have rattled consumer and business confidence. There was also a "polar vortex" that blasted the northern U.S. with unusually cold weather and kept people indoors instead of shopping.

Under Deutsche Bank's new scenario, interest rates would top out at 2.875%, lower than a prior projection of 3.125%, according to the report. 

Bank of America economists wrote in a report to clients on Feb. 15 that the Fed has gone from talking about "restrictive" monetary policy as recently as October to now discussing ending its balance-sheet reductions effort sooner than planned.

"The Fed turned very dovish, very quickly," the economists wrote. "We are now at a point where the Fed is on hold for a prolonged period. We still think that the Fed is more likely than not to hike, but it is becoming a close call."  

Or it's possible that the U-turn already may have happened.