Potential interest rate cut could be acceptance of a new normal
This will be no ordinary interest rate cut.
The Federal Reserve is planning to cut rates at its policy meeting at the end of the month even though the U.S. economy, by most available evidence, is doing perfectly fine.
It appears, based on a close reading of Fed Chair Jerome Powell’s words, to be something deeper than just a tactical response to the latest economic data. It is instead an effort to apply the lessons of the past decade of sluggish global growth and low inflation to Fed policy. It is about accepting a new normal.
And it is an acknowledgment that applying old rules of thumb from the pre-2008 world — under which it would make sense for the Fed to be raising rates now, not cutting them — could be dangerous to a fragile world economy.
Moreover, it is a rare acknowledgment about the inherent uncertainties about the economy, in contrast to a tradition in which central bankers try to project an impression of being all-knowing.
“I am unaware of another Fed chair in history who has, so quickly and clearly, owned the policy uncertainties that the Fed confronts, including when the Fed has gotten it wrong,” said Peter Conti-Brown, a financial historian at the University of Pennsylvania’s Wharton School. “The strategy was to be the Wizard of Oz to the citizens of the Emerald City, not the man behind the curtain to the visitors from Kansas. Powell has opened the curtain and let us in.”
Consider a short narrative of the past two months.
Late May and June brought a weak report on the labor market, a plunge in some surveys of business activity and market volatility as traders bet on Fed rate cuts. It looked like the first stage of a major downturn.
Powell essentially confirmed that lower rates were on the way in his mid-June news conference and subsequent public appearances. But in the past few weeks, the economic weakness has come to look more like a short-term blip than a trend. The job market is quite healthy by any modern standard, according to the latest numbers, and overall growth for the quarter that just ended looks likely to be comfortably in positive territory. U.S. consumers keep spending money, a reality confirmed by a good June retail sales number released this week.
As the economic data has firmed up, Powell has had opportunities to back away from the rate cut message, including in congressional testimony last week and a speech in Paris on Tuesday. He did not do so.
Rather, in those appearances he made a series of comments that suggest that the Fed — or at least its leader — is grappling more seriously than ever before with several ways in which the world economy has changed.
In particular, for years Fed officials talked about the need for “normalization.” They sought to return to the pre-2008 world in which interest rates were comfortably in the mid-single digits and the Fed balance sheet was not stuffed with trillions of dollars in assets accumulated under quantitative easing programs.
But in the speech in Paris, Powell described a series of shifts — toward lower inflation, productivity growth and global interest rates — that the 2008 crisis accelerated.
“The world in which policymakers are now operating is discretely different in important ways from the one before the Great Recession,” he said. He said central bankers might have been laser-focused on fighting inflation even as it started to plunge because “for monetary policymakers in that era, the threat of high inflation felt proximate, the hardfought battle to control inflation having been just recently won.”
The Fed is grappling with the reality that its actions can ripple through the world economy in ways that create powerful feedback loops that endanger the domestic economy.
At times in the past several years, traditional measures of the U.S. economy suggested that it was reaching full health and that interest rate increases might be justified to prevent inflation. But when the Fed’s policies diverge too much from those of its counterparts around the world, it causes the dollar to rise, financial conditions to seize up and overseas economies to slow, in turn endangering the U.S. economy.
In his congressional testimony last week, Powell was uncommonly blunt in discussing the potential for the job market to get better and the apparent failure of the Fed’s traditional models in which low unemployment is expected to fuel inflation.
None of this necessarily means that cutting interest rates now, against the backdrop of a solid economy, is the right move. It could fuel financial bubbles that eventually put the expansion at risk, much as precautionary Fed interest rate increases in 1998, triggered by international turbulence, helped fuel a stock market bubble that popped in 2001.
But by owning up to the ways in which the intellectual framework behind the Fed’s push to raise rates over the past few years isn’t holding up to scrutiny, Powell is sending an important message: As long as he is running the show, the Fed will aim to react quickly to the world as it is, not as the models say it ought to be.