The Federal Reserve is about to do something unusual: Cut interest rates when the US economy is in good shape.
Central bank officials are all but certain to announce the reduction, the first since 2008, when they wrap up their two-day meeting on Wednesday. They will cast the move, which has been telegraphed for weeks, as insurance against the rising risk of a recession. The Fed almost always lowers rates when the economy has already run out of gas.
“It’s better to take preventative measures than to wait for disaster to unfold,” John Williams, vice chairman of the Fed’s rate-setting committee, said in a speech earlier this month.
Williams, who is also president of the Federal Reserve Bank of New York, was speaking about monetary policy theory, not this week’s meeting. Still, he sent a clear signal that the Fed is prepared to give the economy a booster shot sooner rather than later.
But the Fed’s insurance strategy comes with its own risks — most notably, that it won’t work.
The economy, which is in the midst of a record-long expansion, is flashing contradictory signals, making it hard to forecast what direction it will take in the months ahead. Moreover, even after raising rates nine times since the Great Recession, the current target for the Fed’s benchmark rate — 2.25 percent to 2.50 percent — is low by historical standards. The expected quarter-point cut may not do much, and leave officials less leverage when — not if — the next recession hits.
“The Fed is not husbanding its ammunition wisely,” said Robert Pozen, a former chairman of MFS Investment Management in Boston and now a senior lecturer at the MIT Sloan School of Management. “Instead, it’s setting the expectation that it will bail out the economy at every little sign of softness.”
Here’s a look at what’s at stake for the Fed and for us regular folk.
The economy has been growing since 2009, but the pace slowed in the second quarter of this year to 2.1 percent from 3.1 percent in the first three months. While that’s still a respectable rate, some other recent data have been worrisome.
Manufacturing and business investment have waned; growth in China and Europe is weak, which saps demand for American exports; and long-term bond rates are lower than short-term yields, a reversal of the usual relationship that is considered a recession warning.
On the plus side, the job market is strong, with unemployment hovering at 50-year lows, and consumers remain upbeat. Stocks are trading at record highs.
The inflation mystery
Normally, the Fed would not be lowering rates under such relatively healthy conditions. But these aren’t exactly normal times.
First, the chaotic trade situation has hurt business confidence and made life difficult for automakers, farmers, and companies reliant on Chinese customers. The Fed has pointed to global trade as a main area of concern.
Second, inflation has not picked up as would be expected when the jobless rate stands at 3.8 percent. The Fed’s preferred inflation gauge hasn’t consistently hit its 2 percent target for years. Last year, when it looked like prices were finally picking up, policy makers raised rates four times and planned to continue the hikes this year to keep costs from getting out of hand.
But after the fourth increase, in December — and a lot of criticism from investors and President Trump — the Fed had a change of heart. Chairman Jerome Powell pledged to be patient and make future decisions based on the data coming into the Fed. The predicted uptick in inflation never came. The Fed has held rates steady since then.
Why has such low unemployment not driven up wages and other costs, as Economics 101 teaches it should?
“Economists don’t understand it,” said Chester Spatt, a professor of finance at Carnegie Mellon’s Tepper School of Business and a visiting professor at the Sloan School. “I would have never thought you’d have the Fed cutting rates when unemployment is so low.”
The Fed, like a ref who blew a call earlier in the game, may be trying to correct for that final rate hike.
“Milton Friedman had his famous saying that ‘inflation is always and everywhere a monetary phenomenon,’ ” said Peter Ireland, a professor of economics at Boston College and a research associate at the National Bureau of Economic Research. “And if you believe that, it pushes you strongly toward thinking that the December rate increase was a misstep that ought to be reversed.”
The Fed has backed itself into a corner, putting its credibility on the line.
I defended Powell when Trump attacked him and his colleagues for raising rates last year. I don’t believe they are prepping to cut rates now just to please the president. I do think they’ve become too accommodating of big investors.
Yes, a sustained market sell-off can have an impact on the real economy, which is one reason why the Fed paused its credit tightening after last fall’s stock rout. But now, acting without any imminent threats, policy makers seem too eager to avoid another market meltdown.
I get it: Powell doesn’t want a recession on his hands. Low, even negative rates, in other countries complicate his job by driving up the value of the dollar, making US products more expensive overseas.
But he’s setting the Fed up for potential problems down the road.
“Not only will rate cuts leave the Fed with less room, it could destroy the Fed’s credibility just when the Fed needs it most,” said Megan Greene, an economist and senior fellow at the Mossavar-Rahmani Center for Business and Government at Harvard’s Kennedy School. “If rate cuts don’t boost inflation and growth — and I don’t think they will — then no one will believe in the Fed’s tools when the next recession hits. A central bank without credibility is completely ineffectual.”
After Wednesday’s rate cut, the Fed could nudge rates down another quarter-point this year, perhaps at its September meeting.
Barring an unexpected disaster — military confrontation with Iran, complete collapse of trade talks with China — investors will push stocks higher. And they’ll take increasingly more risk to make up for the lack of yield in safer bond investments. Savers will be squeezed once more.
Dan Kern, chief investment officer at TFC Financial in Boston, doesn’t see the harm in the Fed trimming rates a couple of times this year, especially with inflation quiescent.
He argues that while Powell hasn’t acknowledged this explicitly, the easing is designed not only to benefit the US economy, but other countries, too.
The United States “is no longer insulated from the rest of the world,” he said.
But as Kern told me, “There is a fine line between being sensitive to market dynamics and being reactive to market sentiment.”
Powell is walking that fine line. Let’s hope he keeps his balance.