A little over six months ago, observers expected the Federal Reserve to raise interest rates two or three times in 2019. Ahead of the Fed’s meeting in late July, the question now seems to be not whether it will cut rates, but by how much.
How we got here is important. It means the difference between having nothing to worry about and something to worry about deeply.
Last week, Reuters reported that investors rated the chances of the Fed reducing interest rates by 25 basis points at 64%. (A basis point is one-hundredth of a percentage point.) The chances of the central bank cutting rates by 50 basis points rested at 36%. You may have noticed that this leaves a 0% chance of rates staying the same. While the Fed could always surprise us, the markets have fully priced in an interest rate cut next month.
Some observers wonder if the Fed’s likely move to reduce rates is a function of presidential pressure. In fact, I asked a variant of this question myself in April. President Trump has certainly not been shy about making his position public. He has criticized the Fed, and specifically Chairman Jerome Powell, for nearly a year. In a pair of tweets last week, Trump said the Fed “doesn’t know what it is doing” and compared it to a “stubborn child” after it announced it would not cut interest rates in June. Two days later, the president said of Powell: “Here’s a guy, nobody ever heard of him before, and now I made him and he wants to show how tough he is? O.K. Let him show how tough he is.” Powell has generally avoided engaging with the president directly, though he recently made clear he does not think Trump has the power to remove him from his position, in contradiction to Trump’s remarks to that effect.
If the Fed meets expectations and cuts interest rates in late July, the president certainly will not hesitate to take credit. Yet, at this point, I think that Federal Reserve officials will be able to say honestly that their reversal was not a reaction to Trump’s rhetoric. There is another very reasonable explanation: inflation.
Inflation is still quite low by historical standards. There are a variety of ways to measure inflation, but the Fed’s preferred metric – the personal consumption expenditures deflator – shows inflation at 1.5%. We are not experiencing deflation, or even seeing signs that we should worry about the prospect of deflation. But we remain below the Fed’s long-standing 2% inflation target. The Fed may be comfortable projecting that an interest rate cut will help the economy without pushing inflation above its ideal level.
Such a strategy does not come without risks. While I am confident that the Fed understands these risks, I am less confident that everyone else does. Consider Vice President Mike Pence’s remarks in early May: “There’s no inflation; the economy is roaring. This is exactly the time, not only to not raise interest rates, but we ought to consider cutting them.”
This is exactly backward as far as classic economic theory is concerned. Generally, economists expect a central bank to cut interest rates when the country’s economy is weak, not strong. The point of economic stimulus is to encourage business spending and individual consumption in an environment where consumers are not already engaging in economic activity. Lowering interest rates is the equivalent of stepping on the economic gas pedal – something the Fed generally does when the economy is whimpering, not roaring (as per Pence’s remarks).
I can see why politicians are eager to press the economic accelerator, especially heading into a presidential election year. But such thinking betrays a short-term focus. The Federal Reserve should take a longer view. In the long term, the Fed only has so much ammunition for affecting the economy. Using it up when the economy is strong could leave the central bank dangerously unarmed in a crisis. Cutting rates now gives the Fed less leeway to cut them later if it becomes necessary.
Luckily, there are indications that the Fed remains mindful of its mission. Powell has consistently emphasized the importance of policymaking for the long term. “We’re not in the business of really trying to work with short-term movements in financial conditions,” Powell said last week in remarks at the Council on Foreign Relations. “We have to look through that [and] look to the underlying economy for firm guidance.”
The Fed has promised to keep a close watch on economic indicators and to stay flexible. I believe that it will. Cutting rates in late July may simply reflect a changing assessment of the big picture, with the president’s rhetoric correctly relegated to white noise in the background.
We will know for sure based on what happens in the future. If inflation hits 2% and unemployment remains low, then the Fed should return to increasing interest rates. If it does not raise rates at that point, the central bank’s independence will rightfully be called into question. And that would be a major problem for all of us.
Posted by Paul Jacobs, CFP®, EA
photo of Fed Chairman Jerome Powell courtesy the Federal Reserve on Flickr
A little over six months ago, observers expected the Federal Reserve to raise interest rates two or three times in 2019. Ahead of the Fed’s meeting in late July, the question now seems to be not whether it will cut rates, but by how much.
How we got here is important. It means the difference between having nothing to worry about and something to worry about deeply.
Last week, Reuters reported that investors rated the chances of the Fed reducing interest rates by 25 basis points at 64%. (A basis point is one-hundredth of a percentage point.) The chances of the central bank cutting rates by 50 basis points rested at 36%. You may have noticed that this leaves a 0% chance of rates staying the same. While the Fed could always surprise us, the markets have fully priced in an interest rate cut next month.
Some observers wonder if the Fed’s likely move to reduce rates is a function of presidential pressure. In fact, I asked a variant of this question myself in April. President Trump has certainly not been shy about making his position public. He has criticized the Fed, and specifically Chairman Jerome Powell, for nearly a year. In a pair of tweets last week, Trump said the Fed “doesn’t know what it is doing” and compared it to a “stubborn child” after it announced it would not cut interest rates in June. Two days later, the president said of Powell: “Here’s a guy, nobody ever heard of him before, and now I made him and he wants to show how tough he is? O.K. Let him show how tough he is.” Powell has generally avoided engaging with the president directly, though he recently made clear he does not think Trump has the power to remove him from his position, in contradiction to Trump’s remarks to that effect.
If the Fed meets expectations and cuts interest rates in late July, the president certainly will not hesitate to take credit. Yet, at this point, I think that Federal Reserve officials will be able to say honestly that their reversal was not a reaction to Trump’s rhetoric. There is another very reasonable explanation: inflation.
Inflation is still quite low by historical standards. There are a variety of ways to measure inflation, but the Fed’s preferred metric – the personal consumption expenditures deflator – shows inflation at 1.5%. We are not experiencing deflation, or even seeing signs that we should worry about the prospect of deflation. But we remain below the Fed’s long-standing 2% inflation target. The Fed may be comfortable projecting that an interest rate cut will help the economy without pushing inflation above its ideal level.
Such a strategy does not come without risks. While I am confident that the Fed understands these risks, I am less confident that everyone else does. Consider Vice President Mike Pence’s remarks in early May: “There’s no inflation; the economy is roaring. This is exactly the time, not only to not raise interest rates, but we ought to consider cutting them.”
This is exactly backward as far as classic economic theory is concerned. Generally, economists expect a central bank to cut interest rates when the country’s economy is weak, not strong. The point of economic stimulus is to encourage business spending and individual consumption in an environment where consumers are not already engaging in economic activity. Lowering interest rates is the equivalent of stepping on the economic gas pedal – something the Fed generally does when the economy is whimpering, not roaring (as per Pence’s remarks).
I can see why politicians are eager to press the economic accelerator, especially heading into a presidential election year. But such thinking betrays a short-term focus. The Federal Reserve should take a longer view. In the long term, the Fed only has so much ammunition for affecting the economy. Using it up when the economy is strong could leave the central bank dangerously unarmed in a crisis. Cutting rates now gives the Fed less leeway to cut them later if it becomes necessary.
Luckily, there are indications that the Fed remains mindful of its mission. Powell has consistently emphasized the importance of policymaking for the long term. “We’re not in the business of really trying to work with short-term movements in financial conditions,” Powell said last week in remarks at the Council on Foreign Relations. “We have to look through that [and] look to the underlying economy for firm guidance.”
The Fed has promised to keep a close watch on economic indicators and to stay flexible. I believe that it will. Cutting rates in late July may simply reflect a changing assessment of the big picture, with the president’s rhetoric correctly relegated to white noise in the background.
We will know for sure based on what happens in the future. If inflation hits 2% and unemployment remains low, then the Fed should return to increasing interest rates. If it does not raise rates at that point, the central bank’s independence will rightfully be called into question. And that would be a major problem for all of us.
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