Why Did the Fed Lower Interest Rates If the U.S. Economy Is Doing Well?

There are three prevailing theories: 1) insurance 2) political pressure 3) market pressure.

Regarding the first theory, Fed chair Jerome Powell may be trying to pull off what Greenspan did in 1995 and 1998. Powell has characterized both the rate cut in July and the most recent one in September as “insurance.” What he means is that, although the current economic numbers look pretty good, he’s worried about “headwinds” in the near future, specifically regarding Brexit and the U.S. trade war with China. Although trade makes up a relatively small part of the U.S. economy, Powell is more concerned with the effects of policy uncertainty.

This means that businesses are very uncertain of what the U.S. and Chinese governments will do next, and thus will react by delaying investment spending plans rather than run the risk of expanding right before consumer demand dries up.

From the graph below, you can see that investment spending peaked before the trade war started at the beginning of 2018, and the stock market has also been rather bearish on manufacturing ever since.

The main counterargument to Powell’s claim is that these rate cuts may be too small to accomplish very much, and they also draw us dangerously closer to the lower bound of 0%, beyond which monetary policy loses its most powerful tool. It might be wiser to keep rates as they are, thus “preserving ammunition” for a possible larger and more dramatic cut if the economic data does actually weaken You may hear some commentators refer to this alternative strategy as “keeping the powder dry” (scroll down to the “Laying Out Arguments For and Against” section).

As such, the second main theory is that Powell is caving in to political pressure from Trump, who wants lower rates.

Many economists advocate that central banks be insulated from politics as much as possible so as to prevent political business cycles (where politicians temporarily boost employment at the risk of creating an inflationary spiral). As Trump is facing reelection next year and has broken with precedent by commenting publicly on monetary policy issues (criticizing Powell even though Trump was the one who appointed him as Fed chair), it seems likely to me that this is Trump’s goal, although Powell keeps insisting that political considerations play no role in monetary policy decisions.

The third main theory is that Powell is caving into stock and bond market demands for more cuts. Although the Fed officially has two mandates from Congress of keeping inflation under control and maximizing employment, many believe that the Fed has an unspoken third mandate of keeping markets stable. Now, the interest rate that the Fed “sets” is the federal funds rate, and there is a fed funds futures market

where market participants can essentially place bets on what they think the Fed will do. As I recall, whenever Fed actions resulted in a higher interest rate than the fed funds futures market expected, the stock market dropped significantly. Thus, it may be that Powell is trying to keep stock market investors from panicking.

So, there you go: 1) insurance cuts in case things get worse, 2) caving in to Trump’s demands, 3) caving in to the markets. Me, I’d bet on door number 3.

Originally posted at Quora

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