This would be a tough time to be setting monetary policy, even without heckling from the White House. The Federal Reserve just decided to cut interest rates, but not too much, to pep up the economy—even though the economy is doing well.
Is that clear?
It makes a bit more sense if one keeps in mind that the Fed’s influence on the economy is not immediate. Fed officials generally believe rate cuts stimulate the economy with “long and variable lags.” So when Fed policymakers are deciding whether or not to drop rates, they are not looking at the economy of summer 2019 so much as that of end-2020.
The Fed’s statutory task is to pursue full employment and price stability. Right now, both of those look pretty good. The U.S. unemployment rate in June was 3.7 percent, and the number has been at or below 4.0 percent since February 2018. That’s at the low end of the range the Fed considers “full employment.”
Normally, the concern is that such low unemployment will spark inflation. Yet most inflation indices are showing U.S. prices rising at roughly a 1.5 percent annual rate, below the Fed’s 2 percent target.
The last Fed policy loosening came when it dropped the Fed funds rate to roughly zero in the wake of the global financial crisis a decade ago. Then, at the very end of 2015, the Fed started steadily raising the rate again. The latest hike in the sequence came at the end of 2018. So, if things are going so well now, why change course?
For Fed Chairman Jay Powell and those who supported the cut (there was dissent), there were signs of brewing economic trouble. While the Fed traditionally manipulates very short-term interest rates, private buyers and sellers set the yields on longer-term rates. Those longer rates thus tell a story about economic expectations. As the short-term Fed funds rate has been climbing, the benchmark 10-year U.S. Treasury yield has been dropping fairy precipitously. It was around 3.25 percent in November 2018 before dropping to near 2 percent of late.
The fall has been so sharp that it put long-term rates below short-term rates—a situation known as an “inverted yield curve.” Such inversion reflects pessimistic expectations and is frequently taken as a warning sign of impending recession.
Then there are the risks overseas. While U.S. growth has been decent, there are dangers abroad, including feeble economic performance, Brexit and rising debt levels. Powell cited “weak global growth, trade policy and muted inflation” to justify this week’s rate cut. That same volatile U.S. trade policy has also helped sow doubt among U.S. manufacturers, resulting in slow business investment.
While those lurking dangers might or might not develop into full-blown threats to the U.S. economy over the next year or two, the Fed needs to place its bets now. Given the time lags with which rate cuts affect the economy, if the Fed waits to see how these sagas play out, it will be too late to act.
So the Fed decided to stimulate as a precaution.
Or did it? The story gets even more complicated when one factors in market expectations. Market participants had expected at least a .25 percent rate cut this week—which is what they got. But they had also expected that this would be the first of a series of cuts, stretching into 2020. Chairman Powell dampened those expectations in his press conference, prompting equity markets to fall, at least initially.
This expectations game can have significant effects. One would normally expect a U.S. interest rate cut to weaken the dollar, but the currency actually rose against the euro in the aftermath of the Fed move. This likely reflected the judgment that the Fed move was weaker than expected.
The Fed thus placed two big bets today. The first is that there are economic troubles ahead. If so, the Fed will be glad to have provided a (minor) prophylactic boost to the economy. If not, the Fed will likely wish it had held off on rate cuts.
The second bet is that the Fed can make such changes to policy without confusing investors and without appearing to bow to political pressure.
Phil Levy is chief economist at Flexport.