Why is the Federal Reserve’s Open Market Committee contemplating a cut in the benchmark federal funds rate? It really isn’t because it thinks a recession is around the corner, say economists. Instead, the Fed is trying to avoid circumstances in which it is powerless to revive the U.S. economy.
The market-implied probability of a Fed interest rate cut in July 2019 remains above 80%, while the odds of two interest rate cuts in 2019 remain at 89%. Those expectations may be overly optimistic, but they may not be entirely wrong.
The problem is that, given very low unemployment and still-strong consumer demand, a rate cut won’t have the impact it normally would.
“A single interest rate cut might shore up confidence, especially among low-rate-addicted investors, but it won’t do much for an economy at full employment,” says Greg McBride, chief financial analyst at Bankrate.com.
John Dunham, president of John Dunham & Associates, an economic research firm, agrees. “Unfortunately, other than helping to push up asset prices, a Fed rate cut will have no real effect,” he tells CFO. Super-low interest rates for a sustained period mean that the demand for investment capital is already being met, explains Dunham.
Another economist, Jeff Deist of the Mises Institute, thinks a rate cut or cuts could send the wrong signal to businesses and individuals: that they should borrow and consume rather than accumulate capital.
“The last thing our economy needs is more leverage, yet that is precisely what a rate cut encourages,” Deist tells CFO. “The Fed is creating a nation of debtors and allowing Congress to overspend by keeping debt service low. Artificially low interest rates distort the entire economy by encouraging consumption at the expense of saving and capital accumulation, the real source of economic growth.”
The other reason an interest rate cut may be ineffectual is structural. “Most banks are so over-reserved as a result of quantitative easing that virtually none of them are still borrowing at the fed funds rate,” says Robert Phipps, a director at Per Stirling Capital Management in Austin, Texas.
Cutting interest rates could accomplish a couple of things, however. It could change the shape of the yield curve, for one. As of June 14, 3-month U.S. Treasuries were at a yield of 2.2%, while 10-year Treasuries were at 2.09%. (On Thursday, the 10-year yield hit a 21-month low.) Inverted yield curves — when long-term rates are lower than short-term rates — make lending less attractive to banks, “and liquidity in the economy dries up,” says Phipps. Since fed funds is a short-term rate, a cut could cause the yield curve to normalize, making lending more profitable to financial institutions.
An interest rate cut would also put the United States more in line with interest rates globally. “If you look at all the bonds in the world, 27% of them are paying a yield of less than zero,” says Phipps. “Our interest rates are way out of whack to the rest of the world.” That pushes up the value of the U.S. dollar, making U.S. exports less attractive overseas.
A move downward in the benchmark rate may also do something that is not necessarily positive: it will keep the corporate debt bubble from popping. “By keeping interest rates low for so long, we have an extraordinary number of zombie companies that have been only been able to stay alive by financing at incredibly low rates,” says Phipps.
And there are other circumstances that might justify a rate cut.
First, along with some positive economic data, there are some troubling signals as well, not the least of which is lower business confidence. The June Duke/CFO Global Business Optimism survey found economic optimism slipping among U.S. CFOs and CFOs overseas. The U.S. optimism index fell to 65.7 this quarter, down from 70 in September 2018.
According to a Standard & Poors report of June 12, “the outlook for the U.S. economy has worsened since January, with signs that more businesses have closed their wallets and investor skittishness feeding into financial market unrest.”
S&P calls first-quarter gross domestic product growth of 3.1% “deceptive,” driven largely by an inventory buildup and net export strength. “It was more likely tied to trade tensions as businesses tried to get ahead of protectionist actions. More worrisome, private investment and household spending were lackluster.”
The second circumstance is that “we have uncertainty on steroids with the Trump administration,” says Phipps. “We don’t know how and if these trade issues will get resolved.”
Objectively, the current state of the economy and financial markets doesn’t cry out for a rate cut. There is, however, a much more critical reason why the Fed may make a move.
“The Fed has a fear that if they don’t do something proactive, they are going to be battling deflation, and they just don’t have the tools to do it.”
That reason is inflationary expectations. They are at an all-time low, according to the University of Michigan Inflation Expectations Index and other measures (see chart, above). In fact, according to Phipps, the greatest risk in front of the U.S. economy right now is deflation, like that seen in Japan for the past decade.
“The Fed has a fear that if they don’t do something proactive, they are going to be battling deflation, and they just don’t have the tools to do that,” Phipps says.
Fed Chair Jerome Powell has expressed concern that persistently low inflation could lead to a “difficult-to-arrest downward drift in expectations.” Further, Lawrence Summers, former Treasury Secretary, suggested in an April speech that the major industrial economies could be mired in low inflation “for another 10 to 15 years, at least.”
Deflation — reduction of the general level of prices in an economy — is extraordinarily damaging to a consumer-driven economy. It encourages consumers to defer spending as prices come down. If consumers are not buying because prices are falling, dropping interest rates will not incentivize them to resume spending.
The Fed is in a tough spot, however. Damned if it does and damned if it doesn’t. It may want to consider an “insurance” move, says Phipps, because it has insufficient room to lower rates once the U.S. hits a recession. Historically, it has usually taken 550 to 600 basis points to pull the U.S. economy out of a full-blown recession. That was true in 2008, 2001-2002, and 1989-1992. Right now, the Fed only has 250 basis points to work with.
“Recessions that start when rates are low tend to last longer than when rates are high,” points out Phipps. “The Fed doesn’t have much ammunition to counter a recession with, so it takes longer to recover from a downturn.”
Therefore, “the Fed may want to use its limited firepower to delay the onset of a U.S. recession for as long as possible.” The hope would be that in the meantime global economic growth would recover.
Of course, this is also an argument for not lowering interest rates and not taking more “bullets” out of the Fed’s recession-fighting weapon. As a result, the Fed’s strong preference may be to jawbone the markets, says Phipps — to communicate that it stands ready to sustain the expansion.
This week’s FOMC meeting will be an “expectations gaming exercise” says Craig Kirsner of Stuart Estate Planning Wealth Advisors.
The Fed’s main task will be the same as always, he says: carefully craft its language so as to not disappoint the markets. The Fed will have to imply that, “‘Yes, we may not cut right away, but don’t worry, if anything goes wrong we’ll be right there to save you,’” Kirsner says.
“The Fed has created constant proactive interventions that have created the expectation of further bailouts and stimulus,” he adds.
There’s a problem with that expectation. Given where interest rates are today and the possibility of deflation, the next time the economy really needs saving the Federal Reserve may not have the muscle to keep it from falling to rock bottom.