Don’t Fret the Fed

by: Richard A. Anderson

In a widely anticipated, yet highly debated, move, the Federal Reserve (Fed) announced this past Wednesday it is cutting interest rates. The Fed lowered the federal funds target rate range by 0.25%, from 2.25%-2.50% to 2.25%-2.00%. This marks the first time the Fed has cut interest rates since 2008. So, why was the Fed’s decision so controversial?

To first answer that question, let’s dig into the role of the Fed.

The Fed is the central bank of the United States and is tasked with promoting a strong U.S. economy. The Fed’s three functions are to:

· Conduct the nation’s monetary policy.

· Provide and maintain an effective and efficient payments system.

· Supervise and regulate banking operations.

While the three functions of the Fed are equally important in supporting a stable, growing economy, monetary policy is the role most people are familiar with. Monetary policy refers to actions taken by the Fed to control the supply of money and credit with the objectives of maximum employment, stable prices, and moderate long-term interest rates.

The Fed controls monetary policy by setting a target for the federal funds interest rate, which is the rate banks charge each other for overnight loans. The federal funds rate is important because it can impact other interest rates in the economy. Mortgage rates, home equity lines of credit, credit card interest rates, and auto loan rates can all change in response to changes in the federal funds target rate.

The Fed’s use of the federal funds target rate can be compared to the gas and brake pedals on a car. If the economy is slowing, the Fed can give the economy a boost by pressing on the gas pedal. The Fed does this by lowering the federal funds target rate.

If the economy is too strong, the Fed can slow the economy by pressing on the brake pedal. The Fed does this by raising the federal funds target rate.

How much pressure the Fed applies to the gas or brake pedal depends on how quickly it wants to accelerate or brake.

Getting back to the Fed’s decision to lower the federal funds target rate, the Fed is looking to give the economy an extra boost. This is a highly debated move because the economy looks to be on healthy footing. The consumer balance sheet is strong. The unemployment rate is near 50-year lows. Inflation is tame. The real estate market is healthy. There do not appear to be any asset bubbles forming. On top of that, the U.S. economic expansion just turned 121 months old, making it the longest in U.S. history.

With this backdrop, many are questioning why the Fed is giving the economy a boost when it’s not clear the economy needs it. Explained below are seven reasons why the Fed is pressing on the gas to help accelerate the economy.

1. Uncertainty in the global economic outlook.

Economies outside of the U.S. are showing signs of slowing. This weakness could affect the U.S. economy by causing a slowdown in global trade. In addition, a number of geopolitical issues remain unresolved, such as trade negotiations with China, Brexit, and sanctions against Iran.

2. The unemployment rate does not tell the full story.

The U.S. unemployment rate stands at 3.7%, which is a shade above its 50-year low. The labor force participation rate is steady, which indicates that workers are not discouraged and leaving the workforce because they cannot find work. However, this masks the number of underemployed workers, or people who are working in a lower capacity than they are qualified for. Hiring has been greatest in lower-paying jobs. This partly explains why wage growth has also slowed.

3. The link between inflation and unemployment has weakened.

Theoretically, the unemployment rate should be inversely related to inflation. When the unemployment rate is falling, inflation should be rising. This is intuitive because if the unemployment rate is really low, almost everyone who wants a job has one. This means companies are going to struggle to find enough workers who are not employed, so they try to lure them away from other companies by offering higher wages. Higher wages will then force companies to raise the prices of goods or services they sell to offset the increased cost of wages.

This link between inflation and unemployment used to be strong, but it has slowly weakened over the past 50 years to a point where it is almost non-existent.

4. Inflation is below the Fed’s target.

The Fed targets a 2% inflation rate. Inflation has been consistently below this target despite low unemployment, confident consumers, and monetary policy that should encourage spending.

5. The dollar is strong.

U.S. interest rates are higher than most other developed market economies. Look at Japan and Germany, where interest rates on 10-year government bonds are negative. A higher interest rate attracts foreign capital, which in turn causes currency appreciation. The U.S. dollar has strengthened partly because the U.S. has been raising rates over the past couple of years while other global central banks have kept their interest rates low. A strong dollar has positives and negatives. One of the negatives is that U.S. goods become more expensive in overseas markets, which can cause a trade imbalance as we import more than we export. This can be a drag on U.S. GDP growth.

6. The market gets what it wants.

The market had been expecting a rate cut with increasing certainty since early June. These expectations contributed to the recent rally in stocks. The Fed has become increasingly concerned with not causing stock price shocks following the market sell-off in the fourth quarter of last year.

7. The yield curve is inverted.

Yields on longer-term U.S. Treasury bonds are lower than yields on sh0rter-term U.S. Treasury bonds. Historically, when the yield curve inverts, an economic recession follows. We have covered this topic in previous posts (“Q1 2019 Market and Economic Commentary,” “The Yield Curve,” and “Should You Fear a Flattening Yield Curve”).

By lowering the federal funds target rate, the yields on shorter-term U.S. Treasury bonds should fall as well. If the market believes the actions of the Fed will help postpone a recession and lead to higher inflation, longer-term U.S. Treasury bond yields should rise. In a perfect world, this would cause the yield curve to “un-invert.”

In summary, the Fed is looking to get out in front of any potential headwinds that could stall future economic growth. That is why the action by the Fed is being referred to as an “insurance cut.” The Fed is trying to boost the economy in case those economic pressures do lead to weaker economic growth.

The Fed cutting rates is a significant policy change. In the past eight months, the Fed has pivoted from a series of interest rate hikes to now cutting interest rates. In the words of Fed Chair Jerome Powell, the Fed is taking the actions it feels are “appropriate to sustain the expansion.” We believe the Fed’s decision to cut interest rates is a course correction, not a decision to get ahead of an impending recession. Only time will tell whether the Fed’s actions are good, bad, or indifferent, but we believe the stock market and economy have room to run.