The Federal Reserve’s recalibration of monetary policy continued Wednesday, as officials voted to lower the benchmark interest rate by 25 basis points.
Although the decision was widely expected, traders had grown skeptical about the prospect of another rate cut in the days leading up to the meeting. On Tuesday, Fed Fund futures prices implied a nearly 50-50 chance of a rate reduction. On Wednesday, the differential widened to 70-30 in favor of a cut.
Fed Lowers Interest Rates
For the second straight meeting, members of the Federal Open Market Committee (FOMC) voted to lower the target for the federal funds rate by 25 basis points, bringing the benchmark to a range of 1.75% and 2%.
Like the July meeting, Wednesday’s decision was not unanimous with Boston Fed President Eric Rosengren and Kansas City’s Esther George voting to leave rates on hold. Meanwhile, James Bullard of St. Louis voted for a 50-basis point reduction.
The Infamous Dot-Plot
Given that the Fed has never, in its history, forecast recession, we will completely ignore its quarterly projections for GDP, unemployment and inflation. At this point, these estimates are nothing more than political theater.
But the Fed’s now infamous dot-plot summary of interest-rate expectations is always a good conversation starter. The dot-plot charts FOMC members’ best guesswork on the future path of interest rates.
On Wednesday, the chart revealed a longer-run midpoint of 2.5% for the federal funds rate. However, in the near term, officials are pricing in another rate cut down to a range of 1.5% to 1.75%.
Monetary Policy Was Never Going to Be Normalized
By cutting interest rates, central bankers have all but conceded that monetary policy was never going to be normalized in the first place.
Even by the central bank’s own definition, the economy is performing roughly on par with most measures of economic health. Unemployment is near historic lows, job creation is positive, and GDP growth remains firm in the face of global headwinds. The Fed’s engineering of inflation hasn’t been up to par based on its favorite (and deeply flawed) measure – the core personal consumption expenditure (PCE) index.
But other proxies for inflation, such as the core consumer price index (CPI) and average hourly earnings, rose faster than expected in August.
Central bankers have cited U.S.-China trade tensions as one of the main reasons for the dovish pivot, but a closer look at their decision-making reveals they are responding to the stock market. It took a major stock-market meltdown in December 2018 for the Fed to revert to its previous policy stance. After months of posturing, officials in July finally pulled the trigger on a rate cut – their first since the 2008 financial crisis.
Another First for the Fed
Just this past week, central bankers conducted an overnight repo operation to shore up liquidity in the financial system. Like the rate cut before it, the repo measure was the first since the gloomy recession era of a decade ago.
As Business Insider reports, the liquidity shortage was partly due to businesses having to pay quarterly tax bills at the same time the Treasury issued new bonds. The Fed responded by printing tens of billions of dollars in exchange for collateral.
The repo market can be extremely volatile when budget deficits rise. Washington’s budget deficit exceeded $1 trillion in the first 11 months of the fiscal year, its highest since 2012.
How Much Stimulus Is Left?
By lowering interest rates again, the Federal Reserve is exposing itself to new complications if (and when) the next major downturn hits. According to the U.S. Treasury yield, the next recession could be less than two years away.
In times of recession, central bankers usually need a 4 percentage-point cushion to re-start the economy. In other words, the Fed would need to cut rates by 400 basis points for its policies to have any effect on the real economy. Unless negative rates are on the horizon, central bankers have no runway left – and no recourse to respond to the next financial crisis.
If the economy is performing as well as President Trump or the Fed claim it is, interest rates would be rising, not falling. Lowering rates in a real growth cycle goes against all forms of economic orthodoxy that have guided monetary policy over the decades.
If recession is nearing, markets likely won’t know until well after the fact. It took eight months before government economists confirmed that U.S. GDP contracted in Q4 2007. It took another major downward revision to Q1 2008 GDP numbers before anyone knew the United States was in recession.