The Reasons Behind the Federal Reserve's Recent Rate Cut

August 2019 -

In July, the U.S. economy officially passed a significant milestone for the longest period of sustained expansion on record: 121 months. One might assume that the biggest threat during such a stretch would be over-exuberance: investors throwing money at the latest “sure thing,” companies expanding like mad and the Federal Reserve raising interest rates to prevent the economy from overheating. Yet on July 31, the opposite happened when the Fed lowered rates by 25 basis points. The last time the Fed cut rates, in 2008, the Great Recession was underway and the cut, to near zero, was part of efforts to pull the U.S. economy back from the edge of catastrophe. So, what caused this latest action, at a time when the economy is still growing and unemployment remains low?

For answers, Outlook turned to Patricia C. Mosser, an economist at Columbia University’s School of International and Public Affairs. Now the leader of the school’s Initiative on Central Banking and Financial Policy, Mosser worked at the Federal Reserve Bank of New York for more than 20 years, analyzing markets and helping implement monetary reform. Despite the length of the current recovery, the Fed sees signs of potential trouble, Mosser says. There’s an inverted yield curve that has historically been the harbinger of downturns, for example, plus a minefield of geopolitical tensions, particularly around trade policy, and an inflation rate that seems perpetually stuck below where the Fed wants it to be. Mosser discusses what makes this expansion different from others, what economists fear, and what the Fed hopes this latest move will accomplish.

OUTLOOK: Why did the Fed choose to cut rates? Was the size of the cut in line with expectations?

Patricia Mosser: I would call this an insurance cut. That might not be how the Fed would frame it, but it’s definitely a risk-management move. They did this not because the current economic outlook is bad, but because they don’t want it to deteriorate in the future. They want to sustain the economic recovery. Of course, there are people who disagreed with the decision, who wanted to wait and stand pat on rates and see what happens with the economy. The size of the cut wasn’t surprising, especially because Chairman Jerome Powell had telegraphed what he was thinking, and what he understood the Federal Open Market Committee members to be thinking.

outlook-graph-inflation

OUTLOOK: What was the Fed most concerned about?

Mosser: The emphasis was on inflation not being where the Fed wanted it to be. The Fed would be happy if the inflation rate, excluding food and energy, fluctuated from a little below to a little above 2%, but it has remained stubbornly below that target. This relatively small cut in the policy rate actually eased financial conditions from the moment the Fed started talking about it. I assume that was one of their intentions. In other words, we probably saw some benefit from the cut before it was announced. Powell framed the cut as a “mid-cycle adjustment” and pointed to historical precedents for this type of move when rates were similarly lowered in 1995 and 1998. In both cases the economy was relatively strong, but the Fed worried it was going to slow down, and cut rates preemptively.

OUTLOOK: Why the worries now, when the U.S. economy is doing well?

Mosser: The rest of the world isn’t doing as well economically as the United States. The Euro area in particular has been struggling, there’s some weakness in Japan, and Chinese growth has slowed. The U.S. is a big country with a big economy, but it’s not immune to the effects of slowdowns elsewhere. Powell sees two main areas of concern globally.

First is the slowdown in manufacturing, which has been seen in the U.S. and everywhere else. Manufacturing is often considered a predictor of the rest of the economy, and I think the Fed is concerned that manufacturing weakness could spread to other parts of the economy. Second, they are concerned about ongoing trade tensions between the U. S. and China, the world’s two largest economies. That was borne out dramatically just a week after the rate cut when the U.S. announced new tariffs on Chinese consumer goods. China responded by devaluing the yuan and curtailing U.S. agriculture imports, and the Dow dropped 767 points in a single day. These concerns are reflected in the fact that major U.S. companies have been holding back on investment and expansion plans, in part because they are very uncertain about the global trade outlook.

outlook-graph

OUTLOOK: Eric Rosengren and Esther George, presidents of the Boston and Kansas City Feds, dissented from the decision. Was that unusual?

Mosser: Consensus is more typical. There’s a lot of staff analysis that’s shared across the Fed system, much of it generated by the staff of the Board of Governors in Washington, and there’s a lot of internal conversation before these votes. Usually, that’s where differences tend to be hashed out, so there’s consensus by the time a vote occurs. That said, dissents do happen. Both presidents were reluctant to lower rates when the economy is generally doing well. President George is more hawkish and has dissented in favor of tighter monetary policy in the past. President Rosengren has dissented occasionally, but sometimes in favor of easier monetary policy and other times, such as this meeting, in favor of tighter policy.

OUTLOOK: What’s the likelihood that we’ll see further rate cuts?

Mosser: If the economy remains reasonably robust, there wouldn’t be much of a rationale for cutting rates again. But if the trade tensions continue, if the slowdown in investment and manufacturing persists, the Fed may feel it’s appropriate to make another risk-management rate reduction. This decision will be very data dependent. At present, financial markets are predicting that the Fed will lower the federal funds rate target again at their September meeting.

The Fed sees its target of 2% inflation as more or less consistent with price stability…With zero inflation you run the risk of moving into deflation and recession.” 
OUTLOOK: Why is low inflation a problem?

Mosser: It’s all about trying to maintain price stability. The Fed sees its target of 2% inflation as more or less consistent with price stability. The reasons get rather technical, but a slightly positive number seems to work best. With zero inflation you run the risk of moving into deflation if a recession happens.

Part of this has to do with the difference between nominal and real interest rates. Real rates are nominal rates minus inflation, and now, with short-term interest rates just above 2% and inflation below 2%, the real interest rate is only slightly above zero. If inflation goes lower, then the real rate of interest could begin to rise, potentially slowing down the economy even more, which in turn could cause inflation to fall even further below the target (and raise the real interest rate). So the Fed has acted now, to lower nominal (and real) interest rates to help sustain the economic expansion.

OUTLOOK: But doesn’t reducing rates now leave the Fed less room to maneuver if there’s a recession?

Mosser: That could become an issue. Right now, it’s a bigger problem for the European Central Bank, the Bank of Japan and other central banks that already have their rates at zero (or slightly negative) and have economies with very slow growth. But in a typical recession, the Fed tends to cut the short-term interest rate target by between three and five percentage points. The current policy rate target is 2% to 2.25%, so the Fed obviously won’t be able to cut rates by that much. That’s one reason the Fed is so eager to stave off a recession – because if there is one, it won’t have enough space to cut rates as it has in the past.

The Fed has said that it wants to use interest rates as its main policy tool. But it has also said that it wouldn’t hesitate to use its balance sheet again in a recession, through quantitative easing, as it did during the 2008-09 financial crisis. That would mean buying Treasuries and other debt to help the economy.

OUTLOOK: The Fed had been allowing the securities that it acquired during the crisis to mature, gradually reducing the assets on its balance sheet. But now it has said it will stop doing that, ahead of schedule. What led to that decision?

Mosser: I think it was pretty much expected. The Fed had already slowed the pace at which it was rolling off assets in anticipation of stopping in September. Recently its balance sheet had not been shrinking very rapidly – by only $20 billion or $30 billion a month, which isn’t much relative to the overall size. I think the Fed has achieved the vast majority of what it wanted to do when it started rolling off assets a year and a half ago, in terms of reducing the balance sheet to a more manageable size.

The U.S. is a big country with a big economy, but it’s not immune to the effects of slowdowns elsewhere.”
OUTLOOK: How much has the balance sheet been reduced?

Mosser: It was $4.5 trillion in 2017 when the Fed began to let maturing assets roll off, and now it’s about $3.8 trillion. That sounds like a lot, but about $1.7 trillion of that is required simply because of the amount of U.S. dollar currency that’s in circulation. Currency is a liability of the Federal Reserve, and so it has to be offset by an asset on the other side of the balance sheet. That by itself accounts for 45% of the assets on the Fed’s balance sheet.

Another very large part of balance sheet liabilities, about $1.5 trillion, are the reserves that commercial banks hold at the Fed. That’s a big number compared to bank reserves held at the Fed before the financial crisis, but changes in banking regulations now require the largest banks to hold extremely large quantities of liquid assets on their balance sheets – and the safest, most liquid asset available is an account at the Fed.

OUTLOOK: Earlier in the year, President Trump criticized the Fed for not lowering interest rates. Could this latest move be seen as responding to political pressures?

Mosser: I don’t think the president’s statements affected the Fed’s decision. There is a very long history of the Fed making policy decisions based on the economic data and on the policy goals that Congress has given them – inflation and employment. They justified this latest cut in exactly those terms.

OUTLOOK: Are there risks to this interest rate cut?

Mosser: Absolutely. One is the potential for financial instability. In the past 10 years the European Central Bank, the Fed, and the Bank of Japan have maintained a very accommodative monetary policy by historical standards. This extended period of low interest rates is making it quite easy for even risky companies to borrow money. That’s fine as long as the economy is healthy and companies are generally doing well. A lot of businesses look great when financial conditions are easy. But there’s an old saying that bad loans are made during good times, and a slowing economy could pretty quickly expose some of the underlying weaknesses in these companies. Some of them could end up defaulting or having to be restructured, which could precipitate some sizeable losses for investors, potentially leading to financial instability.

Human beings naturally become complacent and we tend to extrapolate from recent experience. In this situation, people may be forgetting that investment prices can go down and things can get very volatile. Moreover, it’s not just the private sector that can be lulled into this way of thinking. Low interest rates make it very inexpensive for governments to borrow. It’s much easier to run big deficits because it doesn’t cost much to finance that borrowing. The U. S. has significantly increased its deficits and its issuance of Treasury securities during the past two years and appears likely to continue to do that for the next couple of years. The latest analysis I saw from the Congressional Budget Office was pretty stark. It showed that eventually the U.S. debt will grow to the point that if interest rates do go up, interest payments could become the largest U.S. government expenditure.

The latest analysis I saw from the Congressional Budget Office was pretty stark. It showed that eventually the U.S. debt will grow to the point that if interest rates do go up, interest payments could become the largest U.S. government expenditure.” 
OUTLOOK: Some observers cited an inverted yield curve as another reason for cutting rates. What does an inverted yield curve tell us about the economy?

Mosser: Normally, bond investors expect a rate premium for buying a 10-year bond versus, say, a 1-year bond, to compensate for the liquidity risk of lending money over a longer term. An inverted yield curve means that interest rates for longer-term bonds are actually lower than rates for short-term bonds. That’s long been seen as a sign that the economy may be headed for a slowdown – because it typically happens when the Fed raises the policy rate, but long-term rates go up by less. But today, I see it more as a reflection of the low interest rates and low volatility that we’ve had for such a long time. So, it’s hard to know whether the yield curve is signaling something important about the economy.

Also in this issue:

  • Interest Rates and Economic Indicators
  • CoBank Reports Financial Results

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