Uncertainty on trade shapes Fed policy options
16 September 2019 | Joe Davis
I've tried to instill in my children that uncertainty is a fact of life that should be embraced. Take the road less traveled. Push yourselves to learn new things, make new friends, and visit new places. It makes life more interesting. But in policy making, persistent uncertainty is not as welcome as a new dinner guest or a long weekend in a new city.
Much has been made in recent weeks about the correlation between inverted yield curves and recession and what it means for U.S. Federal Reserve policy—a valid historical reference point. Inverted yield curves occur when the yields of long-term bonds are driven lower than those of shorter-term bonds, which is the case today.
Until recently, less attention had been paid to the impact of uncertainty, which is elevated at present and also has been reliably associated with lower growth1.
Slowing global growth, Britain's unclear path toward Brexit, and, especially, swirling U.S.-China trade tensions have contributed to what amounts to greater uncertainty today. In an attempt to quantify just how uncertain the global political and economic climate is relative to history, a team of researchers developed the World Uncertainty Index, as shown in the chart. Clearly, uncertainty ebbs and flows over time, but if you look a little more closely, you can see an upward trend in the data. It is this increase in uncertainty, particularly the recent spike, that has started to make its way into policy making discussions at the Federal Reserve.
Economic uncertainty on the rise
Notes: The World Uncertainty Index is computed by counting the frequency of "uncertainty" (and its variants) in quarterly Economist Intelligence Unit country reports for 143 countries from 1996 onward, adjusting for scale. A higher number means higher uncertainty and vice versa.
Sources: Vanguard chart, based on data from policyuncertainty.com.
Following a 25-basis-point cut in short-term interest rates in July, will the Fed make another 25-basis-point cut at its September 17–18 meeting? A 50-basis-point cut that could mollify bond markets and reduce pressure on yields? Or no cut at all, in deference to a still-strong domestic economy?
Although a 50-basis-point cut would be more likely to boost market sentiment and address some of the issues that contribute to an inverted yield curve, we believe the Fed will take the more expected path and choose a 25-basis-point cut. If so, the central bank's target range for short-term interest rates would fall to 1.75%–2.00%.
Fed Chair Jerome Powell has made clear that he sees the rate cut made in July and possible reductions in September or later in 2019 as mid-cycle adjustments, not the start of a sustained series of cuts. In short, the Fed isn't anticipating recession, but slower growth amid lower inflation expectations. Fed policymakers see monetary policy adjustment as a means to prolong expansion; but more recently they have acknowledged limits in their ability to keep an expansion going, owing in large part to increased levels of uncertainty.
Risk is different from uncertainty
The challenge is trying to discern how uncertainty will play out—the uncertainty of uncertainty, if you will2. When it comes to assessing risk, economists and investors alike can identify potential scenarios, assign probabilities, and make educated inferences about potential outcomes. Market participants and policymakers can adjust their outlooks and their behavior accordingly.
Uncertainty, especially with regard to geopolitical risks, including trade, offers no such luxury. Trade policies could change overnight, putting the Fed and other policymakers in an unenviable position. They can try to offset the possible impact of uncertainties on economic targets or, instead, they can base policy on what is known at the moment.
The uncertainty—and perhaps the inverted yield curve as well—won't necessarily be resolved by one or more rate cuts. Uncertainty alone also may not be enough to drive the U.S. into recession. As short-term rates approach zero, though, it's certain that policymakers have fewer options to counter any future shocks that could lead to recession. And the elevated, and likely persistent, nature of uncertainty today is making the situation worse.
1 Source: Known unknowns: Uncertainty, volatility and the odds of recession. Vanguard research, Global Macro Matters series. March 2019.
2 See Barry Ritholtz, "Defining risk versus uncertainty" at https://ritholtz.com/2012/12/defining-risk-versus-uncertainty.
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