The Fed’s Tail-Chasing Problem

The Federal Reserve’s current policy reasoning could push rates sharply lower in response to remote risks

By Justin Lahart

An ounce of prevention is worth a pound of cure,’ said Fed Chairman Jerome Powell. Photo: Associated Press 

The U.S. economy is probably going to be fine, but the Federal Reserve looks likely to lower rates this week anyway.

There is some sense to that: With all the potential economic threats out there, the Fed worries that staying on hold could be riskier than cutting rates. But the danger is that the Fed is entering a spiral where increasingly remote tail risks will lead it to keep lowering rates until it has next to no rate cuts left to give.

With the unemployment rate near a 50-year low, consumer spending solid and inflation beginning to perk up, it seems incongruous at the moment to cut rates. But trade tensions, a slowing global economy and, now, last weekend’s attack on Saudi Arabian oil facilities, all count as reasons to worry.

Those worries are magnified by the fact that the Fed’s current target range for overnight rates, at 2% to 2.25%, is already quite low. That leaves it with little ammunition if it is confronted by a recession—indeed in the past the central bank has had to cut rates by around 5 percentage points in response to a recession.

As a result, the Fed arguably should be readier than usual to lower rates in response to threats, and stave off the possibility of recession, than it might be otherwise. Or, as Fed Chairman Jerome Powell put it in June, “An ounce of prevention is worth a pound of cure.”

Say there is a one-in-five chance that global problems lead companies to reduce employment in the U.S. or spook consumers into spending less. If overnight rates were now set at 5%, the Fed might be more comfortable waiting to see how the situation develops than it is now.

By this logic, however, as the starting rate goes lower, the Fed needs to get even more aggressive responding to remote but worrying possibilities. If policy makers cut rates at the conclusion of their meeting Wednesday and then cut rates one more time this year, as most economists expect, the Fed’s target range will be 1.5% to 1.75% at the start of 2020.

If the Fed then perceives a one-in-10 danger, should it cut rates in response? Where does it end? Rates could end up slipping toward zero even before an actual downturn materializes.

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