The Fed Cut
On September 18th, the Federal Reserve announced its first interest rate cut since 2020. The upper-limit interest rate target had been 5.5 percent. Everyone expected a cut this month, as the Fed had forecasted one well in advance. The surprise was the size. The Fed usually prefers quarter-point moves in times of general economic stability. This time, the cut was 0.5 percent, or a half-point, making the new upper-limit target 5.0 percent.
Previous half-point cuts occurred during Covid, The Great Recession, the dot-com bust, and after September 11th. Those were all times of economic stress. Today, however, the economy is doing pretty well. Inflation has gone down. The unemployment rate is a wonderful 4.2 percent. To my knowledge, unemployment has never been this low when the Fed chose to cut rates by a half-point.
This immediately sent markets into a tizzy. The S&P 500 and DJIA set record highs. Crypto prices went through the roof (wasn’t crypto supposed to be a hedge against traditional asset prices?). At first glance this is all good news. Inflation is still elevated but has come down. Unemployment is at historic lows. The stock market is rallying for everyone except those who invested in Peloton. After the chaos of shutting the economy down, giving trillions of dollars to everyone except apparently economics professors, and inflation the like of which hadn’t been seen since Ronald Reagan, things are going well.
The looming concern with a rate cut of this size is inflation. Inflation may have decreased in the last two years, but it’s important to note that it’s still elevated. Remember, inflation refers to how much prices are increasing - prices are never returning to their 2019 levels. The goal with inflation is always to stop the bleeding, not remove the bullet. The Fed targets a 2.0 percent inflation rate using the PCE measure of prices. The PCE peaked in June 2022 at 7.1 percent. It’s since come down to 2.5 percent. That’s great progress, but it still isn’t 2.0 percent. Prices aren’t going haywire like in 2022, but they are still increasing faster than the Fed would prefer. The PCE has also been at 2.5 percent or higher since February, so progress has stalled for six months.
The Fed has two remits directly related to interest rates: keeping inflation low and unemployment low. The problem is that these two measures are often in opposition to each other, at least in the short run. At any point, the Fed could temporarily decrease unemployment by cutting rates sharply, but that would increase inflation. Conversely, the Fed could successfully fight inflation by increasing rates quickly, but that would increase unemployment. This necessitates a constant balancing act. Interest rates that are too high will cause unemployment. Interest rates that are too low cause inflation.
On top of that, there are two additional challenges.
First, changes to the interest rate take weeks to months to percolate down through the economy. The Fed has to try to anticipate future market conditions and act accordingly. Second, the correct balance between inflation and unemployment is one of opinion. We can all agree that if inflation is at 8 percent and unemployment is at 3.5 percent, the Fed should raise rates to combat the sky-high inflation and risk unemployment deteriorating from excellent to good. But what about today? Inflation is higher than it should be, but only marginally so. Unemployment is low, but higher than it was six months ago. There are several options the Fed had that most economists would agree are reasonable.
Was the half-point rate cut reasonable? Just. In my Overton Window of Fed options, they could have left rates as they were, cut them by a quarter-point, or cut them by a half-point. Increasing rates by a quarter-point would have run counter to the strategy the Fed has employed for the last four years of preferring inflation to unemployment, which would be bad to change on short notice. Cutting rates by 0.75 points would have sent the message that the Fed is no longer committed to fighting inflation, and is only interested in unemployment. Anywhere in-between could be justified.
So the half-point cut was appropriate, but barely. It signals the Fed is more concerned with low unemployment than elevated inflation. In defense of the Fed, they are trying to project things forward. Inflation has stabilized for six months while unemployment, while still low, has been trending upward. Should those same trends continue for the next six months, inflation would still be only slightly elevated, while unemployment would be leaving “good” territory and entering “average”.
While defensible, I think this was the wrong decision for several reasons. First, politics. No matter what the Fed did this month, people would be angry. Cutting rates will stimulate the economy and likely help the incumbent party, in this case the Democrats, while leaving rates unchanged would raise unemployment and likely help the Republicans. The issue is that most objective observers agreed that a quarter-point cut was the most sensible. Why they chose to deviate from the middle course of action from both a policy and political angle is odd.
Second, I’m worried the Fed hasn’t learned from its past mistakes. They were asleep at the wheel in 2022, electing to leave rates low even when inflation had been double their target rate for well over a year. It seemed obvious to me that the inflation that began in the Spring of 2021 was not temporary, and that giving people trillions of dollars, then limiting what they could spend it on, was going to cause inflation. To be fair, some economists argued that inflation was transitory, although they were in the minority. Regardless, the Fed acted too slowly, keeping interest rates low even though inflation was rising and unemployment was falling. If inflation comes back with the rate cuts, the Fed’s decision-making now makes me question its stated commitment to fighting inflation. Fool me once/fool me twice. To be slow to act when the economy is in uncharted waters is one thing; to be too slow to act in more normal times is less defensible.
Third, I’m concerned the Fed is letting the deficit affect its decision making. The federal government is overspending by a stupendous stupendous amount. More is added to the national debt every year than used to be added every decade. This is bad for a host of reasons, but is worsened by high interest rates. By lowering rates, the Fed is easing the stress the deficit will put on the economy. That may sound like a good thing, but it’s the wrong way to go about the fixing the problem. To ensure economic health, the government has two levers, fiscal policy and monetary policy. Congress and the President are responsible for the former (the government budget) and the Fed for the latter (interest rates).
I’m sympathetic to the attitude that since Congress has abdicated from having responsible fiscal policy, the Fed needs to step in and help. This might be modestly effective in the short run but will be disastrous in the long run. If Congress believes that the Fed will balance reckless spending with interest rate cuts, what do you think they will do? They will spend more! Just as universities lick their chops when they see near limitless loans being provided to students by the government and raise tuition, so too will Congress take advantage of generous loan terms by running higher deficits.
The Fed has decided to prioritize unemployment over inflation. The last time they did so, it resulted in the fastest price increases in a half-century. Will that happen again? Right now it’s far too early to tell. I find it heartening that one Fed Governor voted against the consensus, the first dissenting vote by a Governor since 2005. If the Fed moderates its course over the next six months, we will avoid a repeat of 2022 inflation. Perhaps they wanted to send a strong signal for this meeting, and if inflation ticks up in the coming months they will change course. They have not overcommitted (yet). Overall, I have faith in the Fed despite its recent missteps. I hope that faith is well-placed.