New York: 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 US economy, by most available evidence, is doing perfectly fine.
It appears, based on a close reading of Fed Chair Jerome Powell’s own 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 last decade of sluggish global growth and low inflation to Fed policy.
It is about accepting a new normal.
And it is an acknowledgement that applying old rules of thumb from the pre-2008 world — under which it would make sense for the Fed to be raising rates right now, not cutting them — could be dangerous to a fragile world economy.
Moreover, it is a rare acknowledgement 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 last two months.
Making Fed decisions more plainly obvious
Late May and June brought a weak report on the labour 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 last 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.
American consumers keep spending money, a reality confirmed by a good June retail sales number.
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. He did not do so.
Rather, in those appearances he made a series of comments that suggest 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 “normalisation”. 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 programmes.
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.
No going back to pre-2008 times
“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 that central bankers might have been laser-focused on fighting inflation even as inflation started to plunge because, “for monetary policymakers in that era, the threat of high inflation felt proximate, the hard-fought battle to control inflation having been just recently won.”
John Williams, the president of the Federal Reserve Bank of New York, made a related argument in a speech. He emphasised that the low-interest-rate world that had taken hold since the financial crisis called for a different approach to signs of trouble — in particular, quicker action.
“First, take swift action when faced with adverse economic conditions,” Williams said at a conference. “Second, keep interest rates lower for longer. And third, adapt monetary policy strategies to succeed in the context” of rates that are persistently near zero.
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 last several years, traditional measures of the American 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 US economy.
Avoid a disconnect with rest of the world
This happened to varying degrees in 2013, when the Fed under Ben Bernanke sought to “taper” its quantitative easing programme, and again in late 2015 and early 2016, when the Fed first raised interest rates under Janet Yellen, and again at the end of 2018 under Powell.
“Pursuing our domestic mandates in this new world requires that we understand the anticipated effects of these interconnections and incorporate them into our policy decision making,” Powell said in Paris. In practical terms, that can be viewed as part of the rationale for the imminent interest rate cut.
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 right 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 last 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.