The Federal Reserve’s Wednesday decision to cut interest rates is, on one level, unremarkable.
Price inflation is running below the Fed’s 2 percent target and has been for a while, and there’s no clear evidence of inflation around the corner. There are some troubling signs of economic weakness abroad, and President Donald Trump’s ongoing trade wars and intermittent threats of tariffs on some of America’s largest trading partners have some people worried. But fundamentally, the case for a rate cut is just a question of the basic logic of the inflation rate.
Yet on another level, it’s a stunning development. Rate cuts normally come in times of recession and high unemployment. Today’s unemployment rate is below 4 percent, and the economy has been expanding for the longest period on record. With such a low unemployment rate, there’s no precedent for interest rates being as low as they were before the rate cut, to say nothing of afterward. Nevertheless, we are getting a rate cut — a modest move from 2.5 percent to 2.25 percent — that represents the first downward revision in the key policy rate since the 2008 crisis.
Beyond being historically unusual, the Fed’s decision represents a striking reversal of the logic that governed monetary policy since the winter of 2013-’14. This doctrinal evolution is one of the most quietly significant aspects of contemporary policy and politics, helping explain both why Trump won the election in 2016 and why he has decent odds in 2020.
Interest rate basics, explained
Monetary policy is complicated, but the basics are actually pretty simple. The Federal Reserve, America’s central bank, can try to make interest rates go higher or lower. Lower rates mean it’s cheaper to finance investments in home renovations, business equipment, and other expensive durable goods. That helps create jobs and stimulate the economy. But in an overstimulated economy, you get soaring prices and may need higher rates to slow things down.
During the Great Recession, the Fed used its main rate cut tool to bring short-term interest rates all the way down to zero. But the economy was still depressed. Congress enacted a big fiscal stimulus, but it wasn’t as big as experts thought the circumstances warranted. Soon after, a new GOP Congress began to enact austerity budgets, further inhibiting any Keynesian path out of the recession. The Fed resorted to multiple rounds of unusual “quantitative easing” programs (where it basically bought a bunch of longer-term bonds) in an effort to boost the economy. This brought the Fed under a lot of political criticism, and it was plainly happy to start backing away from QE as early as December 2013, even though the labor market still wasn’t especially healthy.
The mentality was these were controversial emergency measures, and as long as there was no emergency, the Fed should reverse them even if there was no inflation.
Then during 2014, 2015, and 2016, the Fed made it clear that the near-zero interest rates themselves were an emergency measure. They wanted to “normalize” rates (in their phrase of choice) as soon as possible, rather than waiting for inflation to materialize. This helped slow GDP growth in 2016, depress farm prices, and make the US dollar more expensive, thus depressing American manufacturing output. All this likely contributed to Trump’s narrow win (Vox argued repeatedly at the time that the Fed was making a mistake) but then continued across the first two years of his administration.
2019 has been different. After a bunch of complaining from Trump, his newly installed Fed Chair Jay Powell announced a pause to rate hikes January. Today, he announced a cut. The Fed remains committed to higher rates as an inflation-fighting tool if needed but is no longer committed to normalization as a goal on its own terms. That’s good news for Americans at the margins of the labor market (the long-term unemployed, high school dropouts, ex-offenders, etc.) and good news for Trump, whose presidency is being kept afloat by strong economic data. But thinking about Trump shouldn’t obscure the sheer consequences of the turnabout as a policy matter.
It’s not clear where we go from here
One issue here is simply the perception that the Fed has changed direction under pressure from Trump. The Fed of course denies this, and as someone who was arguing for less emphasis on normalization long before Trump won the election, I’m inclined to agree that the argument was just persuasive on the merits.
It wasn't Trump pressure.— Kai Ryssdal (@kairyssdal) July 31, 2019
It was market pressure/expectations.
Really really important difference. https://t.co/sp6pHyst0B
However, it’s undeniable that Trump wanted the Fed to change course and then the Fed changed course.
Under President Obama, both the White House and the Treasury Department maintained a firm taboo against commenting on monetary policy. That was half a genuine sense that it would be inappropriate and half a belief that commentary would be counterproductive — inducing the Fed to move in the opposite direction to demonstrate its independence.
But beyond that, by Obama’s last couple of years in office, his team mostly believed that the economy was already operating at full employment with little room for additional stimulus to be effective. That was, at least according to the Fed’s new thinking, wrong. Which means that, somewhat embarrassingly for the Democratic Party, Trump turns out to have had a better grasp on a key macroeconomic policy topic than their all-star team of technocrats.
Policymakers now face a huge question going forward: If interest rates are going to stay low — and perhaps even fall — with the unemployment rate low and the economy growing, then what’s going to happen when a recession does hit?
One of the key arguments for “normalizing” was the idea that it was important to get back to high interest rates so there was plenty of room to cut them again if a recession came. That idea never really made much sense (it’s like gorging on pizza to make it easier to lose weight later), but the fact that it’s now clearly not happening seemingly leaves the burden of economic stimulus to lawmakers. In theory, Congress could put its partisan differences aside and come together to deliver a massive fiscal stimulus on a timely basis. But nobody remotely familiar with the operations of Congress should find that idea reassuring.
This all raises the question: If another recession occurs, what exactly is the plan?