The Fed cuts while keeping its cool

The Fed cuts while keeping its cool
© Greg Nash

As expected, the Federal Reserve’s interest-setting Federal Open Market Committee voted to lower the target range for the Federal Funds Rate on Wednesday by 0.25 percent. The announcement came in the wake of a rather unexpected bout of turbulence in the repo markets, a murky corner of the financial world poorly understood by most outsiders. More predictably, the Fed’s move was greeted with denunciations by the White House.

Readers may well be concerned about the seriousness of this week’s turbulence. Seemingly out of nowhere, interest rates on the Fed’s transactions involving the temporary sale and later repurchase of U.S. Treasury Securities spiked by some 3 percentage points, or perhaps even more, on Monday. These transactions are not subject to high levels of reporting disclosure; the Fed only reports data on a whole week’s repo trading. For this reason, even the facts of the case were hard to establish.

In the end, the Fed seems to have calmed the situation with substantial interventions into the markets on Tuesday and Wednesday, the first such operations since 2008. I and other observers were puzzled about the sudden increased demand for funds in a situation when commercial banks, the Fed’s main partners, are reported to hold some $1.5 trillion dollars of reserves in accounts at the Fed above and beyond what the Fed requires. Clearly, someone else needed cash.

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Chairman Powell addressed the matter in his comments at the post-meeting press conference. He stated that the Fed had been aware of the upcoming need for financing, but was somewhat surprised by the intensity of the reaction. He also clearly stated that he did not believe that the demand surge was a symptom of widespread liquidity problems in the financial sector. He argued instead that they would not have an effect on the broader economy. While tighter rules on bank’s liquidity and capital buffers could conceivably have made the situation more intense, Powell stated that he would rather maintain the tough rules that keep the financial system safe, while providing more liquidity if and when the need emerges.

In short, the repo tremors do not seem to presage broader instability, let alone the return of the crisis conditions of 2007.

But what about that rate cut?

Overall, the Fed’s assessment of the current state of the economy has not changed much. Consumers keep spending, maintaining a decent pace of economic growth. Unemployment is low, new job creation continues but has slowed down a bit, something one would expect when relatively few workers are actually available. Inflation remains below the Fed’s 2 percent target.

The continued absence of strong signs of increased inflation explain the Fed’s willingness to cut. The headwinds have gotten a little bit stiffer: Companies are increasingly hesitant about buying new equipment and building new factories, and builders are not starting large numbers of new homes. Uncertainty about the future direction of the economy, heightened by the baffling course of the trade wars, clearly is weighing on investment.

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Additionally, manufacturing output has sagged. Coupled with stronger signs of weakness in Europe, where the European Central Bank’s latest measures suggest a degree of desperation, and in China, all of this points to a risk of slowing economic growth. Unusually, the Fed feels that it has some room to respond, since it is not very worried about setting off significant increases in inflation.

Chairman Powell was quite reluctant to tip his hand on further action. He coolly refused to engage with criticism from the White House that the Fed should do more to bolster the economy. But he did make two major points: First, monetary policy can only do so much. It cannot build bridges and roads, nor can it actually affect the long-run rate of growth of the economy. Second, the government has much more powerful tools in its hands in the form of fiscal policy.

Finally, Powell noted that lower interest rates abroad do put downward pressure on U.S. interest rates. Increased flows of money to the U.S. by investors looking to take advantage of higher interest rates and earning opportunities here serve to strengthen the dollar, lowering U.S. inflation and interest rates on Treasury securities, a favorite of investors the world over. These considerations reinforce the Fed’s disposition to lower rates.

Notably, three members of the FOMC dissented, an unusually high number. Two favored keeping the Federal Funds Rate unchanged, one preferred an even larger rate cut. Powell characterized this as “healthy disagreement”; it is also testimony to just how difficult it is to read the contradictory signals from both the economy and the White House.

In short, the Fed has once again provided some support to the U.S. economy, while making clear that it cannot ride to the rescue all by itself.

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.