The FED: Pandering or Independent?

Admittedly there are concerns about a two pronged attack on US net exports, which is a component of GDP – the continued plunge in the British pound and the euro against the US dollar as a no-deal Brexit looms, and the of-and-on, with no progress, trade talks between the US and China – but an interest rate cut is possibly premature when stacked up against other, perhaps more important, data.

US GDP growth for the second quarter of the year was higher than forecast at 2.1% and while it was lower than the 3.1% growth rate for the first quarter, growth reflected faster spending by households, whose spending contributes to more than two-thirds of GDP. The unemployment rate for June at 3.7%, continues to be well below the natural rate of unemployment, and non-farm payrolls increased by 247,000, which is both healthy and higher than what was added the previous month, and inflation, by all gauges, remains tamed. Importantly, banks have substantial liquidity given the Fed’s interest on reserve policy, which has contributed to keeping inflation in check. Other macro level indicators of economic activity buttress continued growth in the economy, so it is not particularly clear why the Fed would need to cut interest rates.

Political Influence?

What however is clear has been the fact that the President has continued to rail against the Fed in his tweets that they should not have raised interest rates at all last year and should rather have acted to cut interest rates. There was even concern last year that the President was looking into the possibility of having Powell removed as Fed Chair.

Having raised the benchmark interest rate late last year, the Fed has since then adopted a wait and see approach, leaving interest rates untouched as the economy has weathered the impacts of the trade war with China, a government shutdown, and stock market volatility quite well. It is true that the global supply chain linkages in production means that any slowdown in global consumption will necessarily affect the US economy similarly, but given how strong other fundamentals are and the fact that trade is a relatively small part of the US economy, it is not clear how much of an adverse effect this should have absent any stimulus from a rate cut or series of rate cuts.

Interest rate cuts are politically desirable if they can come with little to no costs, or if the costs are hidden or can be dispersed. Inflation can readily be chucked up to being the norm during an expansion, or blamed on monetary policy, so it costs very little from an electoral perspective, as compared with a recession. Interest rate cuts both help to stave off a recession and provide cheap credit to investors, the main beneficiaries being stock holders as stock prices get boosted.

The Economics of a cut

When the Fed announces an interest rate cut it intends to lower the Federal Funds Rate by the amount it states the interest rate will fall by. The Federal Funds Rate is the interest rate at which banks borrow overnight loans out of the excess reserves they have on deposit with the Fed. The Fed will therefore purchase bonds from banks and credit the bank accounts with the amount of the purchase, until there is sufficient amount of excess reserves to cause the Federal Funds Rate to fall to its target level.

The presumption here is that with an increase in excess reserves and resulting lower borrowing rates for depository institutions, they will be more likely to provide loans at cheaper rates to the public. Investment spending is therefore expected to increase as will household credit -based spending. Further, because lower interest rates make bonds more expensive to hold compared to stocks, investors will tend to move assets into stocks and this boosts stock prices, increases consumer wealth and spending.

Where there is any slowdown in economic activity, such spending would stimulate the economy by providing impetus for further spending by offsetting reduced spending elsewhere. In this case, because we are not in a recession, such a rate cut is intended perhaps to keep spending elevated so that what might have been a slowdown from other sources – through a reduction in our exports, and in net exports – is prevented.

Potential Downside

The problem in my opinion is there isn’t enough reason to believe a rate cut is needed. A premature rate cut has many downsides to it.

First, interest rates have not risen high enough since the last recession to return them to regular levels, so using this tool when we are not in a recession may reduce its effectiveness if it turns out to be really needed down the road. It should be noted that fiscal policy may be emasculated given that we have already passed a tax reform bill that has significantly cut taxes and raised our deficits for the foreseeable future so that should a recession take hold on the economy it is not clear how much stimulus will come from fiscal policy.

Second, interest rate cuts lead to artificially low rates that do not reflect the true market condition and these tend to create asset market bubbles. Busting market bubbles tend to precede recessions and not even rushed monetary policy can prevent them from running their course. Again, we may see the Fed whip out its nontraditional toolkit but investors are better prepared to predict this and the end result may not be what the Fed had intended.

As stated earlier banks are already very liquid. The negative side of the 2.1% growth in the economy for the second quarter was due to reduced spending on inventories and nonresidential fixed investment. This suggests the economy is already saturated and flooding the economy with additional money may not provide any more stimulus for businesses to take out loans and spend if inventories are not being depleted. Banks may simply keep on holding on to the excess funds and keep earning interest on them - so what we have is simply a redistributive policy that enriches the banks with the potential for future inflation in the offing.