The Fed’s dovish turn looks like a surrender
The Federal Reserve is expected to cut interest rates soon. Many will view such cuts as a surrender to pressure from Donald Trump. But the Fed must not become the president’s poodle. It needs to be careful about what it does.
In testimony to Congress this week, Jay Powell made the case for the Fed to cut rates, by emphasising “uncertainties about the outlook”. In response markets expect a cut of 25 basis points in July. Consensus forecasts, according to Bloomberg, are for one further cut this year. Some analysts forecast two more — which would bring rates back to where they were in May 2018. It would also mean that real short-term interest rates were close to zero, again.
Yet Mr Powell also insisted in his testimony that “our baseline outlook is for economic growth to remain solid, labour markets to stay strong, and inflation to move back up over time to the committee’s 2 per cent objective”. Gross domestic product increased at an annual rate of 3.1 per cent in the first quarter. This rate is above potential, as is shown by the continued fall in unemployment from 3.9 per cent in December 2018 to 3.7 per cent in June, which is “close to its lowest level in 50 years”.
Given this, it is hard to see a strong case for a cut, let alone a series of cuts. So what might explain it? Mr Powell himself pointed to two considerations. First, there is a degree of weakness in domestic demand, notably in business investment. Second, and presumably more significantly, he pointed to “ongoing cross-currents from global growth and trade”. Cuts might then be seen as insurance against the possible consequences of such threats. The irony is that a principal explanation for lower interest rates would be Mr Trump’s trade war. He is then in effect killing two birds with one stone.
The Fed can only contemplate taking out such insurance because inflation is so low. Indeed, there are two remarkable features of the economy.
One is that nominal demand has not really exploded upwards, despite the combination of loose fiscal and monetary policies, by historic standards. This supports the hypothesis of “secular stagnation” — that is, structurally weak demand. After all, if rates were now cut, the peak in this cycle would be less than half of what it was in 2007.
The other is that inflation and inflation expectations remain so well under control. On the personal consumption expenditure index, core inflation was just 1.6 per cent in the year to May 2019. The gap between yields on inflation-indexed and conventional 10-year bonds suggests expected inflation is just 1.8 per cent.
Persistently low inflation greatly reduces the risks of taking out the “insurance”. But that does not make it wise. One risk is that the strong economy ultimately does what strong economies do: raise inflation faster than people expect. The other is that, given the balanced nature of the argument, the Fed will be seen as dancing to Mr Trump’s expansionary tune. Yet the Fed is an independent institution for a very good reason. It is not its job — and it must not be seen to be its job — to deliver re-election to the president.
This then is a fine judgment. It may be that the world economy will turn down, in which case the Fed is rightly protecting the US economy from the fruits of the president’s bad trade policies. It is also possible that the US economy will continue to expand robustly, in which case the Fed will be adding fuel to the fire, for insufficient reason. Yes, persistently weak inflation gives room to cut. But the risks of being seen to bow to political pressure and to fuel asset market bubbles are large. The Fed must remain both data-dependent and cautious, not terrified of shadows.