In one sense, you could say that Wednesday’s decision by the Federal Reserve to cut rates was of minimal importance. The interest rate the Fed more or less directly controls — the federal funds rate — is the rate at which banks lend one another money overnight. And it’s hard to think of any businesses or consumers who will change their plans because the annualized interest rate on one-day borrowing has fallen a half a percentage point, from around 5.5 percent to around 5 percent — which means that if you borrow $1,000, your repayment the next day falls by 1.4 cents.
Yet it was a momentous move all the same. For one thing, Fed rate changes tend to percolate into longer-term interest rates that really do matter for the economy. For example, the series of rate hikes the Fed undertook in 2022 and 2023 drove 30-year fixed mortgage interest ?g=1tROk” rel=”noopener noreferrer” target=”_blank”>rates up to almost 8 percent from about 3 percent.
Even more important, by beginning to cut rates, the Fed — which began raising rates in 2022 in an attempt to control surging inflation — in effect declared its belief that the war on inflation has been won.
Why should we care what the Fed thinks? Let me tell you a secret: Jerome Powell, the Fed chair, and his colleagues don’t have any inside information about the state of the economy. (OK, they might have advance warning if, say, a major bank is about to fail.) Most of their decisions are based on the same data about unemployment, inflation and so on available to anyone with an internet connection.
It’s true that the Fed has some very smart economists on its staff. But there are plenty of smart economists outside the Fed, too. The implicit declaration that inflation has been defeated won’t come as news to anyone who has, for example, been following Mark Zandi at Moody’s or Jan Hatzius at Goldman Sachs, who have been telling us for months that inflation is under control.
Yet the Fed gains some perceived gravitas from its policy role, which means that its opinion carries special weight with investors and, perhaps more important, the general public.
So it matters that the Fed is now sounding the all-clear on inflation. But this good news raises two questions.
First, if inflation is, as Powell said in his news conference, close to the Fed’s target of 2 percent, why didn’t he and his colleagues cut rates even more?
The Fed committee that sets interest rates, which meets eight times a year, normally moves those rates gradually — a quarter point at a time. The big debate before this meeting was whether this would be a standard quarter-point cut or, what we actually got, a “jumbo” half-point cut.
But instead of thinking in terms of increments, suppose we just ask what interest-rate level makes sense at this point. Inflation appears to be under control; labor markets appear to be weakening, with unemployment still fairly low but up significantly from its low point last year and hiring falling off. Overall, as Powell said in his news conference, the labor market looks a bit cooler than it was on the eve of the pandemic.
Yet the overnight rate was 1.75 percent at the end of 2019. There are some iffy arguments to the effect that we can maintain full employment at a somewhat higher interest rate now; participants in Wednesday’s committee meeting projected on average that the interest rate will settle at 2.9 percent. But I haven’t seen any plausible case for a “neutral” rate higher than 4 percent at the most. Yet despite the jumbo cut, rates are still at 5 percent. Shouldn’t the Fed be moving more quickly to normalize rates (and minimize the risk of a recession)?
Second, will the Fed’s all-clear do anything to persuade more Americans to re-evaluate President Biden’s economic record? We did experience a temporary burst of inflation in the aftermath of the Covid-19 pandemic, but so did almost every other major economy, while we have generally had much stronger growth than our peers have. And as White House economists have pointed out, our success in getting inflation back down has defied the expectations of commentators who insisted that disinflation would require a big rise in unemployment.
I know that some people aren’t satisfied with returning to low inflation; they want to see us get the level of consumer prices back to what it was before the pandemic. But we can’t, and even trying would be a really bad idea. Over the past century, only one president has presided over a significant decline in consumer prices; his name was Herbert Hoover.
Today’s Fed move is, of course, good for Kamala Harris. It will give consumers some direct relief on interest costs, and it will signal that high inflation is in the rear view mirror. And having Powell say, as he did in his news conference, that the economy is in “good shape” has to be helpful for a candidate who is part of the administration presiding over that economy.
And almost too predictably, Donald Trump jumped in to suggest that the Fed might be “playing politics.”
But while the Fed’s action will surely have political consequences, it wasn’t a political decision. The straight economic case for a rate cut was overwhelming; the case for a big cut was very strong. Not cutting would have been political. And the Fed didn’t let itself be bullied into inaction.
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