Too soon to know if Fed rate cut will help avoid recession

Too soon to know if Fed rate cut will help avoid recession
© Greg Nash

Federal Reserve Chairman Jerome Powell had been signaling for some time that the Federal Open Market Committee (FOMC) was likely to cut the Federal Funds Rate for the first time since the low-point of the Great Recession in late 2008. And so it did. At Wednesday’s meeting, the Fed cut the key interest rate 0.25 percentage points.

Usually, a Fed rate cut would mean that the economy had taken a nosedive. The Fed often acts before a recession has been officially identified. But most often, the Fed only cuts rates when the economy is sending very clear distress signals, such as a significant rise in the unemployment rate.

This week’s rate cut does not fit this pattern, making it unusual but not unprecedented. Signs of economic weakness are not hard to find, most notably declines in residential construction and in purchase of capital goods and equipment by U.S. companies. Both of these could just be normal results of an expansion that has run out of steam. After 10 years of an expanding economy, it gets harder to find new places to build houses and new buyers to purchase them. Something similar happens with building new factories and buying new equipment.

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But readers probably need no reminding that this is not a garden-variety expansion. Economic policy in the Trump era is marked by drama and unpredictability. The trade war with China has been the most salient case. Companies contemplating expansion seem unsure how to proceed, not knowing whether to count on supply chains including Chinese companies. Since investment decisions require a careful look into the next five to 10 years of economic activity, uncertainty on the scale we are now experiencing can simply lead firms to hold off, waiting for greater clarity when the dust settles.

Which brings us back to the Fed. The central bank’s leaders have made it clear that they see the economy as generally strong. U.S. consumers continue to spend at a steady pace. Since consumption accounts for almost two-thirds of total spending, things are unlikely to go too far south if consumers keep their wallets open.

But there is that weak investment. And U.S. exporters are faced with slowing economies in Europe and yes, China. These factors are slowing growth down, but not yet dragging us into recession.

The Fed’s interest rate cut is meant to offset some of this weakness. However, it is far from clear whether companies perplexed by the direction of the trade war will really be any more likely invest because they can get a slightly cheaper loan. This seems even more likely given Powell’s clear statement that this week’s cuts are not the start of a longer series of cuts.

The limits of this week’s actions are also underlined by the fact that two of the nine voting members of the FOMC voted against the cut. Dissents are rare; multiple dissents at one time are rarer. Clearly, the Fed’s leadership is not united behind an all-out effort to boost the economy.

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All of this leads me to look at this week’s action with a bit of a jaundiced eye. The Fed has cut the federal funds rate. It will also now seek to maintain the size of its bond portfolio rather than allow it to shrink. Some financial market participants have seen the portfolio shrinkage as even more powerful than the Fed’s increases to the Federal Funds Rate, since the portfolio shrinkage decreases demand for Treasury bills, lowering their price and raising long-term interest rates such as mortgage rates.

These actions certainly shift the Fed’s posture. Since 2014, it had been removing stimulus or even slowing down the economy to avoid overheating. Now it is staying neutral, even providing a tiny dose of help. The Fed is not riding to the rescue; it is showing some concern about the economy’s frailties but only offering some mild encouragement.

The stock market immediately got the message, heading downward once Powell’s post-meeting news conference hit the airwaves. The Fed’s most vociferous critic, the one in the White House, will no doubt weigh in too. But it will take more time for this drama to unfold fully.


Evan Kraft is the economist in residence for the economics department at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.