Risk assets have rallied sharply on anticipated monetary policy easing. But if the FOMC has already taken policy into restrictive territory, a couple of “insurance” cuts will provide little stimulus in the presence of headwinds from trade policy and the global slowdown in manufacturing.

For these reasons we continue to believe our reduced risk positions in portfolios remain warranted. These include moving up in quality, shortening spread duration, and over-weighting non-cyclical sectors relative to cyclicals.

What a difference a month makes. In the course of June the S&P 500 rose by about seven percent, briefly touching a new high for the year, and credit spreads tightened. The risk rally came despite renewed trade tensions with China, and a tariff threat against Mexico that signaled the potential use of trade policy as leverage in any number of future international disputes. Meanwhile, incoming data point to a slowing manufacturing sector, and payrolls data suggest decelerating jobs growth that extends to the services side of the economy.

At the risk of understatement, such developments would not typically provide a tailwind to risk assets. Instead, investors have attached significant weight to the shift in Federal Reserve communications about the monetary policy outlook. These communications have reinforced market expectations for 75–100 basis points of policy easing over the next year, with many investors now expecting a first interest rate cut as soon as the meeting at the end of this month.

All else equal, lower interest rates will provide some support to the economy. However, we are skeptical that the 50 basis points of easing that many FOMC participants project by end-2020 will make a material difference to the growth outlook. First, the Federal Reserve’s Senior Loan Officer Opinion Survey already suggests weakening demand for both consumer and business loans. If weaker loan demand reflects greater uncertainty about the economic outlook, a marginally lower cost of funds is unlikely to entice potential borrowers off the sidelines to a meaningful extent.

More importantly, we believe that it is quite likely that the FOMC has already over-tightened policy. Our belief stems from two considerations. First, core inflation has disappointed over the first half of this year, with the year-over-year core PCE inflation rate falling by about forty basis points. This has had the effect of increasing the real policy rate this year, even without any change in the nominal federal funds rate target.

Second, there is a substantial body of evidence suggesting that structural factors such as an aging population, reduced business investment and higher demand for safe assets have lowered the neutral policy rate, which is the rate consistent with trend growth and inflation at the central bank’s target. Relative to this low neutral policy rate, a seemingly modest 225 basis points of nominal policy tightening since 2015 may have already taken policy into restrictive territory.

These effects of disinflation and a low neutral policy rate on the policy stance can be seen in the chart below. Here, we calculate the real policy rate by subtracting core PCE inflation from the federal funds rate. We then take the difference between the real policy rate and an estimate of the neutral policy rate, using estimates from the Federal Reserve Bank of New York. The result suggests somewhat restrictive policy, similar to what was observed ahead of prior recessions.

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