The Fed cut short-term interest rates by 25 basis points today, moving the range for the federal funds rate down to 2.00 - 2.25%. It also announced it will stop reducing its balance sheet in August, two months earlier than previously planned.
It made these moves despite better-than-expected economic data since the last meeting in June, as well as Chairman Powell's assessment at the press conference that our economic performance is "reasonably good" and the outlook is "good," as well. The Federal Reserve still claims it's "data dependent," but no one should believe it.
We don't think today's rate cut was needed, and would prefer that they continue to shrink the balance sheet. Nominal GDP is up 4.0% in the past year, and is up at a 5.0% annual rate in the past two years. Both figures stand well above the Federal Reserve's target for short-term rates. On policy, we agree with Esther George and Eric Rosengren, bank presidents for Kansas City and Boston, respectively, who dissented stating they preferred no change in rates at today's meeting.
We think cutting rates by 25 basis points was the worst possible policy outcome. If the Fed was determined to cut rates, it should have committed further – by 50 basis points or more – to tell businesses and consumers considering big-ticket purchases the Fed is planning for one-and-done. By cutting rates only 25 basis points and leaving alive expectations of further gradual cuts at coming meetings – drip, drip, drip – the Fed has created an incentive to postpone economic activity. Powell said the Fed wasn't committed to a series of rate cuts, but didn't give markets a reason to believe it. After all, at the June meeting the median interest rate projection from the Fed was for rates to remain unchanged through year-end.
The Fed's statement justified the rate cut based on "global developments" and "muted inflation." At the press conference, Powell referred to the European Union and China as points of global concern. But US monetary policy is not the tool to address these problems. Powell also suggested the Fed is concerned with a "downward slide" into lower inflation expectations. It is true that the Fed's favorite inflation measure, the PCE deflator, is up only 1.4% from a year ago. However, it's up at a 2.2% annual rate in the past three months. This is not an environment where deflation seems like much of a risk.
Putting aside whether the Fed is doing the right thing, we think the Fed is likely to reduce rates by another 25 basis points in September. In for a penny, in for a pound. The current environment remains bullish for equities, which were cheap even without rate cuts. In the meantime, holders of long-term bonds will eventually come to regret policies that mean a faster pace of inflation over the long run.
Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist
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