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Curing the Fed’s Rate Cut Confusion

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Curing the Fed’s Rate Cut Confusion

August 7, 2019

As expected, the Federal Reserve reversed course last week, lowering interest rates by one-quarter percentage point and thereby undoing the last in a series of nine rate hikes that began in December 2015. My previous essay for E21 described how this policy turnaround can be justified by the Federal Open Market Committee’s latest forecasts, which project slower U.S. inflation and weaker economic growth than expected last fall.

At his press conference immediately following the policy announcement, however, Federal Reserve Chairman Jerome Powell described the rationale for the rate cut in a different way. His comments appeared to confuse many listeners.

To be sure, summarizing the complex economic arguments underlying the case for any monetary policy action can often be quite a challenge. Complicating matters in this case, President Trump’s very public criticisms of Fed policy have made Chairman Powell’s job even more difficult, requiring him to stress repeatedly that the Fed sets monetary policy based on economic considerations alone, without influence from politics. But if the FOMC made its interest rate decisions with reference to a specific monetary policy rule, all of these communications challenges would become easier to manage.

Chairman Powell began his press conference by listing the three main factors that led the FOMC to reduce interest rates. The rate cut, he said, “is intended to insure against downside risks from weak global growth and trade policy uncertainty . . .  and to promote a faster return of inflation to our symmetric 2 percent objective.” The problem with this list is that of the three factors cited—weak global growth, trade policy uncertainty, and persistently low inflation—only the third is one that can be addressed directly by Fed policy.

Stabilizing inflation is, of course, the Fed’s principal economic function as our nation’s central bank. Since the financial crisis and recession of 2007-09, U.S. inflation has run persistently below the Fed’s long-run 2% target. That inflation has still not converged back to that target provides a good argument for reversing at least some of the monetary tightening that the Fed put in place last year.

It is far less clear how more accommodative monetary policy in the U.S. can make up for slowing growth in Europe and China. And the idea that last week’s interest rate cut is an appropriate response to changes in trade policy is even more problematic. This is because monetary policy can, at best, generate more rapid economic growth in the short run. There’s absolutely nothing the Fed can do to offset the adverse effects that tariffs have on growth over longer horizons.

Moreover, by suggesting that lower interest rates can offset the negative effects of tariffs, the FOMC risks destabilizing expectations. Will last week’s rate cut be followed by others now that, to use Chairman Powell’s words, trade negotiations have gone again from a “simmer to a boil”? If so, where and when will the self-reinforcing cycle of higher tariffs and lower interest rates finally end?

At the press conference, CNBC’s Steve Leisman expressed exactly these concerns. Mr. Leisman asked the Fed chairman if we are now “more in the realm of watching headlines of trade talks than we are watching unemployment rate and inflation numbers or . . . growth numbers?” Following up, he wondered, “how do we know what you’re going to do next and why . . . in this new regime?”

The answer to Mr. Leisman’s first question has to be that we are not in a new regime of the kind he describes because Federal Reserve monetary policy is powerless to offset the costs of tariffs and other disruptions to international trade. His second question, meanwhile, practically begs Chairman Powell and his colleagues on the FOMC to make more consistent reference to a specific monetary rule that summarizes their systematic approach to setting interest rates. Although the exact form of this rule should be chosen by Committee consensus, it would almost surely take a form similar to the one originally proposed in a 1993 article by Stanford economist John Taylor, describing how the FOMC’s federal-funds-rate target responds to changes in inflation and one of the two other variables mentioned specifically by Leisman: U.S. unemployment or economic growth.

Importantly, such a rule would not make direct reference to tariffs or the growth rates of other economies around the world. The rule would also exclude other variables, like stock prices and measures of financial market volatility, that the Fed is largely if not entirely powerless to affect. Consistent reference to that rule would not require the FOMC to completely ignore developments in the global economy and disturbances in financial markets. But it would make clear that the Fed takes those factors into consideration only to the extent that they influence the outlook for U.S. unemployment or growth and, especially, U.S. inflation—the variables specifically in the rule.

Finally, reference to a specific monetary policy rule, linking the federal-funds rate to a small number of economic variables under the Fed’s influence, would help Chairman Powell continue to emphasize that FOMC decisions are not influenced by politics. In the past, FOMC members have always resisted calls to adopt a specific monetary policy rule. But the economic and political challenges they face today provide them with a strong reason for adopting a policy rule now.

Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.

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Photo by Zach Gibson/Getty Images

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