There were good reasons for Jerome Powell’s Federal Reserve to cut interest rates on Wednesday, but its action brings its own risks
By Justin Lahart
Federal Reserve Chairman Jerome Powell Photo: sarah silbiger/Reuters
The Federal Reserve has cut interest rates and it has given its reasons why. The big question now is whether those reasons will hold up.
The central bank’s decision on Wednesday to lower its target range on overnight rates by a quarter-point hardly counts as shock after all the signaling Fed policy makers provided.
Considering the Fed was raising rates just over half a year ago, though, its policy shift is something of a head-scratcher—especially with the unemployment rate near 50-year lows and the stock market near records.
But the Fed is worried that weaker global growth and trade tensions are casting a pall over U.S. business spending and that there is a risk it might spread to other areas of the economy. In its statement, it also pointed to muted inflation pressures as a factor in the decision to lower rates—a nod to worries that the longer inflation remains below the Fed’s 2% target, the more ingrained too-low inflation will become in consumer expectations.
Additionally, some influential Fed policy makers have argued that because rates are already low, leaving them with less room to cut in the event of a downturn, pre-emptively cutting to head off risks lest things get out of hand makes sense. Or as Fed Chairman Jerome Powell recently put it, “an ounce of prevention is worth a pound of cure.”
The Fed may end up being correct on all three counts. If, for example, economic data weaken over the next several months, its worries about global spillovers will look prescient and its move to act pre-emptively will seem wise.
But the Fed also could be wrong in its assessment, and that carries its own risks.
Take its concerns about how global weakness and trade uncertainty are hitting businesses: An analysis conducted by UBS economists suggests that declines in business investment and manufacturing activity earlier this year were driven by last year’s tariff increases and that those effects are now fading. The Fed, on the other hand, thought that any tariff effects would be small and has misread the slowdown as a confidence shock that could persist, the UBS economists argue.
The cooling in inflation that it is worried about also could end up being more noise than signal given how easy it is for figures to bounce around in a low-inflation environment. Its preferred measure of inflation, excluding food and energy costs, advanced at a 2.5% annual rate in the three months through June after increasing at just a 0.5% rate in the first three months of the year.
Finally, while acting pre-emptively to head off danger when rates are low seems like a good idea, that is only if the danger is really there. Simulations run by economists at Goldman Sachs showed that following pre-emptive rules doesn’t actually lower the risk of recession. In some cases they lead policy makers to ease aggressively in response to false alarms, leaving them short of ammunition later. Moreover, the economists found that following such rules can lead to increased financial volatility and asset-price excesses—economic risks in their own right.
Stocks fell Wednesday after Mr. Powell signaled caution on whether the Fed would keep easing.
Considering the costs more cuts could come with, that caution may be warranted.
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