by Dr. Charles Lieberman
Chief Investment Officer
Fed Chairman Jerome Powell signaled quite clearly that the FOMC will lower its policy rate at its July meeting. But should it? Powell justified reducing rates by pointing to inflation being below the Fed’s 2% target, while the trade war with China and weaker growth overseas increase uncertainty over the economic outlook. At the same time, growth remains strong enough to continue driving down the unemployment rate even further, risking higher inflation. The case for reducing rates seems hard to justify on economic criteria.
The case for the Fed lowering rates is based on inflation remaining below the 2% target while the growth outcome is uncertain. But Fed officials only recently suggested that the dip in inflation was “transitory” and the latest data supports that view. The Dallas Fed’s trimmed mean inflation gauge remains right at 2%, the core PCE deflator has ticked up to 1.6% and the core CPI is at 2.1%. No matter which measure is used, inflation is either at or only slightly below the Fed’s 2% target. So while it may be desirable for the Fed to push up inflation to its target, or maybe slightly above target, it is questionable whether that objective justifies making monetary policy even more accommodative than it is already. There’s a far better case for the Fed to be patient about altering policy than to become more accommodative with firms generally reporting that hiring remains their greatest business challenge.
The second justification for reducing interest rates is that growth is weakening and the outlook is uncertain. But how weak is growth when job gains have been positive for 105 months in a row, unemployment filings and unemployment are around 50-year lows and job openings are at record highs? The strength of the expansion is also manifest in corporate profits, which are also at all-time highs, as is the stock market, while interest rates are near 50-year lows. And with 10-year Treasury yields below 2%, real rates are close to zero even without taking taxes into account. So monetary policy remains accommodative, which raises the question: why reduce rates even further?
It is possible that the impasse over trade with China will not be resolved any time soon and this makes planning more difficult for business. Even so, growth continues unabated, subject to its normal ebbs and flows. And it is also entirely possible that growth will remain comfortably above trend, the unemployment rate will plumb new all-time lows and labor scarcity will promote a significant rise in inflation that requires a restrictive monetary policy. We wouldn’t favor raising interest rates to fight this possibility now, because it hasn’t occurred, as yet, although that case is clearer because the trend points that way. But this makes the logic of the alternative policy of reducing rates even more difficult to understand because there’s no evidence of below-trend growth of the economy. That possibility remains nothing more than a hypothetical event.
Sometimes Fed policy actions are justifiable on the basis that allowing a weak economy to result under an unchanged policy is very costly, while a rate reduction would risk pushing inflation above target, a less painful outcome. But the risk of a recession seems to be quite low. The data shows nothing to suggest there’s a recession visible on the horizon. When the Fed last lowered rates deep into an expansion in 1998, Greenspan was reacting to the nearly simultaneous default of Russia and the collapse of Long Term Capital Management, which sent disruptive shock waves through the economy. In contrast, risk spreads are near record lows today. And with real interest rates around zero for the entire yield curve, policy is highly accommodative. So the Fed’s apparent decision to reduce rates seems highly questionable and is likely to prove to be a mistake. So we expect market to party on.
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