What’s wrong with a 50 basis-point interest-rate cut?
I’m all for central banks doing their utmost to support high, durable and inclusive growth. But this doesn’t mean throwing everything at the wall when the economy is doing relatively well, financial markets are buoyant, and policy ammunition is limited.
Growing pressure on the Federal Reserve to cut interest rates by 50 basis points this month is unwarranted. By complying, the Fed would serve the short-term interests of financial asset holders at the risk of greater difficulties down the road.
Expectations for Fed policy action follow a familiar pattern: No matter how much and how often financial markets get what they wish for, they always ask for more. Expectations have continued to outpace the Fed even as it has, in the past seven months, made a remarkable U-turn.
In December, it signalled two rate hikes for 2019. By March, it was guiding toward no rate hikes. And in June, it practically guaranteed a rate cut as early as this month.
Markets can’t have enough of Fed action
Yet markets are not content to let Fed policy guidance converge on what’s already priced in. They’re now pressing for as many as three rate cuts in coming months, with growing (if not yet overwhelming) calls for a 50 basis-point cut in July.
The justification for lower rates has also evolved: Whereas they used to be touted as “insurance” against economic weakness abroad and trade-policy uncertainty, they’re now starting to be seen as a shock-and-awe approach to keeping the economy strong — even though it’s already, as Fed Chair Jerome Powell likes to put it, “in a good place”.
The markets’ desire for rate reduction is understandable. Investors have benefited enormously over the past few years from a rare combination of higher valuations, low volatility and unusual correlations that have seen the prices of virtually all assets, risky and risk-free, rise in unison.
This remunerative mix has had a lot to do with ample central bank liquidity, reinforced by confidence that monetary policy will step in with more whenever investors feel threatened.
But it’s hard to make a strong case for a 50 basis point rate cut using more conventional criteria. Economic momentum in the US may be somewhat weaker than it was last year, but it remains solid — with unemployment at a near five-decade low, inflation not that far from the Fed’s target, and financial conditions very loose.
Moreover, it is far from guaranteed that additional monetary easing would have a material effect on economic performance (as opposed to market performance).
At the same time, there are costs and risks involved in going beyond an insurance cut at this stage: Asset prices could become further decoupled from fundamentals, and markets too comfortable with ample liquidity.
Politicians would be given another reason to dither on pro-growth policies. The Fed could be seen as buckling to political pressure, undermining the institutional credibility that is so critical to policy effectiveness.
Policy ammunition to counter future downturns would be reduced. Companies would be encouraged to take on even more debt, and investors to stretch even further for returns.
And the markets’ insatiable appetite for continuous central bank support would only continue.
Other economies would draw their own conclusions and react
Meanwhile, other countries could well interpret an unusual degree of Fed monetary stimulus as a backdoor effort to weaken the dollar against their currencies. This would increase the probability of a currency war in a global economy that’s losing momentum.
Already, the floating currencies of several open economies have weakened in response to the trade dispute between China and the US. Attempts to depreciate the dollar could create trouble as countries seek to insulate themselves from foreign exchange pressures.
Protective actions — from implicit devaluations to explicit market intervention — would feed back to the US. Keep in mind that monetary policy is a marathon, not a sprint.
A 50 basis-point cut by the Federal Reserve at its end-of-July meeting would not only risk exhausting its critical policy-making tools but also threaten the country’s economic well-being.