The Marriner S. Eccles Federal Reserve Board Building, Washington, D.C.
Photo by Wikimedia Commons user TheAgency (CJStumpf).
By nearly all measures, the U.S. economy continues to expand. Unfortunately for the governors at the Federal Reserve, this means that each cut in interest rates will become harder to justify.
In late July, the central bank cut its key interest rate, the federal funds rate, for the first time since 2008. Federal Reserve Chairman Jerome Powell characterized the July cut as a “mid-course correction” – a way to offset the rate hike in December 2018, which critics attacked as too extreme. The Fed is scheduled to meet again next week and most investors expect another interest rate cut, with more to follow later this year. But amid signs of a strong economy, it is far from clear that further stimulus is justified. With each future interest rate cut, the Fed risks the appearance of caving to political pressure.
The current target federal funds rate is a range of 2% to 2.25%. A standard cut of 25 basis points (a basis point equals one-hundredth of a percent) in September would mean a new range of 1.75% to 2%. Economists like to see a smooth, upward slope when graphing the relationship between bond yields and bond maturity dates; this is the “yield curve” whose inversion you may occasionally hear analysts worry about. With the 30-year Treasury note currently yielding about 2%, the Fed may have to keep cutting short-term rates, eventually going as low as 1%, or even less. Assuming the Fed continues to reduce rates 25 basis points at a time, this would mean at least four more rate cuts after September.
That’s a lot of stimulus for an economy that appears to be firing on most, if not all cylinders. The job market, stock market and gross domestic product are still strong. While jobs growth in July was weaker than anticipated, the U.S. unemployment rate continues to hover near a decades-long low of 3.7% nationwide. Stocks, meanwhile, are near their all-time highs. And while the Atlanta Federal Reserve’s GDPNow tool estimated GDP growth of 1.5% for the third quarter, a decrease from the prior estimate, the measurement still represents overall economic expansion.
Proponents of continued interest rate cuts argue that inflation remains quite low. I observed this myself back in early July. The most recent consumer price index measure is 1.8% above its level 12 months prior. The Fed’s preferred inflation gauge, the Personal Consumption Expenditures Price Index, has climbed 1.4% over the past 12 months. Given such low inflation, it is reasonable to think that Fed governors are not concerned about pushing inflation too high by cutting interest rates by a quarter of a percent. Yet, as I have said before, cutting rates now means the Fed is leaving itself less ammunition to combat a future economic crisis. Just because the Fed can cut rates does not mean it should.
Another argument for cutting rates is that the Fed needs to offset the damage created by the global trade war. But this is a tough position to take, because the July cut appears to have prompted the president to step up the trade war. The day after the Fed cut rates in July, President Trump announced tariffs on an additional $300 billion of Chinese imports. Another cut may lead to more of the same, offsetting any good the interest rate adjustment might do on its own.
Beyond low inflation and offsetting the results of the trade war, there is another nonpolitical argument for cutting interest rates. Some analysts have suggested that, as foreign central banks continue to cut interest rates, we have to keep up with them or risk disruptions. The European Central Bank sets three key interest rates for the eurozone, including an interest rate on deposits currently sitting at -0.4%. The ECB may cut rates even more deeply at its upcoming meeting. Nor is Europe the only factor. The Bank of Japan’s short-term interest rate is -0.1%. Fed critics worry that a widening gap between domestic and foreign interest rates could lead to a spike in the dollar’s value, which could hurt exports and domestic manufacturing.
I am not convinced by this argument. While the Fed should be mindful of what its foreign counterparts are doing, since when do we have to tie our interest rates to foreign central banks? While the administration has made its displeasure at a rising dollar clear, the situation would likely play itself out with less damage and distortion if left alone. First, the dollar won’t rise against other currencies forever. If our (relatively) high interest rates push the dollar high enough, a few things will happen. Foreign money will pour into America on a major scale as investors take advantage of higher rates and other investment opportunities here. Eventually, the pendulum would swing back. If investors sell their foreign bonds in large numbers, foreign yields should increase and become more competitive with the U.S., which would lead to currencies flowing back out of the U.S. to take advantage.
Second, while a strong dollar means our exports will suffer, it also means Americans will be able to buy more abroad, and perhaps a lot more – not just toys, clothes and electronics, but also major expenditures such as businesses and infrastructure assets. The situation could essentially become the mirror image of the past 10 to 20 years in trade relations between the U.S. and foreign countries, including China. For years, we spent our dollars abroad and other countries used those dollars to buy not just Treasurys, but also physical assets, businesses and more. If managed carefully, such a reversal in our purchasing power could benefit all levels of the country, including sectors that don’t directly benefit from a rising dollar.
Eventually, this too would pass. By buying foreign assets, the U.S. would have to convert dollars into foreign currencies, which would prop those currencies up. Exchange rates would reach a new equilibrium, and consumers and businesses would adjust. This is a much more likely outcome than a never-ending spike for the dollar or a death spiral for foreign currencies.
When the administration insists on interest rate cuts, it demonstrates a lack of faith in free markets and actively undermines those markets. Cutting rates when economic conditions are strong uses monetary policy ammunition we will eventually need. Pressure from the administration also undermines the Fed’s independence, and runs the risk of distorting and damaging our economy.
There is one more possibility, of course. The Fed may genuinely see evidence in its economic data that something terrible is around the corner. But I am skeptical of this argument. I assume an interest rate cut next week is a given, but if our economy continues to grow, I would prefer that the central bank’s governors hold firm. In the future, they should communicate that the right thing to do in good times is to raise interest rates, so policymakers have more room to cut them when stimulus is necessary.
Any family that has to save for retirement and balance their checkbook understands the trade-offs between short-term gratification and providing for necessities 10, 20 or 30 years down the road. The Fed should too, even in the face of ongoing White House pressure.