As anticipated, the U.S. Federal Reserve cut its benchmark interest rate Wednesday, the first such a cut in over a decade. The move is intended to balance mounting economic uncertainties and the Fed indicated that it is ready to do more if warning lights continue to flash. There remains, however, the danger that the Fed — like central banks elsewhere around the world — is losing ammunition that it will need if a real crisis occurs.
The U.S. Federal Open Market Committee (FMOC), the official name of the 10-member group that sets interest rates, dropped its key interest rate by 0.25 point — to 2.25 percent — the first reduction since December 2008, when the world was in the grip of a financial crisis. The Fed also announced that it would end its program to divest itself of the $3.8 trillion in financial assets — Treasury bonds and mortgage-backed securities — that it had acquired in the aftermath of the crisis to provide liquidity to the economy and keep interest rates low. That effort was originally scheduled to end in two months; its termination is another means to ease pressure on the economy.
In a statement announcing the decision, the Fed justified the move by noting “uncertainties,” in particular “the implications of global developments for the economic outlook as well as muted inflation pressures.” In a news conference after the decision was announced, Federal Reserve Chairman Jeremy Powell blamed “weak global growth” and “trade policy” for what is generally considered an insurance measure.
While the market had priced in the cut, there was some surprise that Powell was not ready to commit to more cuts later in the year; the Dow Jones Industrial Average on the New York Stock Exchange dropped over 300 points. The FOMC statement left the door open to future reductions — the Fed has almost always had multiple cuts and Wall Street is pricing in three more cuts this year — but Powell was more circumspect, noting that “it is not the beginning of a lengthy cutting cycle.”
Conditions are uncertain. Every institution and respected economist acknowledges the mounting headwinds created by the Trump administration’s readiness to launch trade fights, the prospect of a “no-deal” Brexit, the slowing of the Chinese economy (the country posted its lowest growth in 26 years) and a similar deceleration in Europe.
Japan’s economy is slowing too, with government forecasts for growth dropping to 0.9 percent from 1.3 percent for the year through March. The Bank of Japan projected Japanese growth of 0.7 percent for the year through March 2020, a drop from the April forecast of 0.8 percent.
The U.S. is fine, however. Powell explained that “there is really nothing in the U.S. economy that presents a prominent near-term threat … there is no segment or sector that is really boiling over.” The economy has recorded the longest expansion in U.S. history. Consumer spending, which accounts for about 70 percent of economic activity, grew 4.3 percent in the April-June quarter, and unemployment is at near historic lows.
There are some reasons to be cautious, however. The economy has slowed, with the government revising down its estimate of 2018 growth from 3 percent to 2.5 percent; most experts expect it to slow further to 2 percent in the second half of the year. They blame the waning effects of the 2017 tax cuts that supercharged growth. Inflation remains persistently low and wage growth is anemic.
But while the Fed must be alert to those risks, it must also be conscious of two other concerns. First, there is the danger that lowering interest rates could fuel a bubble in stock or other asset markets. Corporate debt is already at a record high and easy money will stimulate not just growth but bubbles in stock and real estate markets.
A second concern is that lowering rates now reduces the tools that the Fed will have in the event of a future crisis. The Fed must be able to provide stimulus if there is a downturn and the more it cuts interest rates now, the less room there is for similar action in the future. This constraint assumes additional significance when governments are reluctant to provide fiscal stimulus to struggling economies. To its credit, Japan has proven less inclined to do so, although economic decision-makers will be challenged when the consumption tax is increased later this year. The stimulus from the 2020 Tokyo Summer Olympic Games will help balance that shock to the system.
That is a year away, however. There is ample time for that shock and many others. The Fed must maintain its capacity to address both expected and unexpected developments. Its decision this week reduces its margin of error and increases the burden on other central bankers to be ready to step up as well.