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Why Did the Fed Lower Interest Rates?

September 10th, 2019 by 
CameronDaniels

Back on Wednesday, July 31st, 2019, the Federal Reserve lowered the federal funds rate for the first time in eleven years.

In future articles, I will discuss why I find this move and its timing peculiar. For now though, I wanted to lay out some short-term implications and how I think this impacts the economy.

Balancing Inflation with Unemployment

The federal funds rate is the primary interest rate that banks charge each other for excess deposits.

A lower federal funds rate, in general, encourages investment and business spending by lowering the cost of borrowing from other banks. Another way of saying this: a bank’s reward for maintaining excess deposits decreases, so they will look for riskier investments.

If the interest rate is higher – say 5% – then a bank will need a very high return to beat their risk-free rate. If the interest rate is lower, then riskier bets that return only a couple percentage points may still be worth it.

The primary purpose for lowering interest rates is to spur the economy.

Spending and investing more should lead to higher wage growth and lower unemployment. All of this has a drawback: it risks creating more inflation.

The current inflation rate (measured by CPI) is low but in range, hovering in the 1.5%-2.5% annualized range.

The Fed, then, had to lower rates on different grounds.

China Trade Concerns, Stock Market and Uncertainty

The Fed gave a few reasons for why they cut. From their minutes:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 2 to 2-1/4 percent. This action supports the Committee's view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective are the most likely outcomes, but uncertainties about this outlook remain. As the Committee contemplates the future path of the target range for the federal funds rate, it will continue to monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.

Federal Reserve Minutes from 07/31/2019

As tariffs trade back and forth between the USA and China, manufacturers and consumers may decide to cut back on their spending due to the wealth effect. The wealth effect shows that as prices increase, a household’s actual wealth and income goes down.

You can see this move as a move in advance of future spending – and declining consumer confidence.

What about the stock market and GDP?

Another reason for a rate increase? Likely uncertainty in both the stock market and real GDP, the ultimate measure of the total output of an economy. (Although I should mention, both stock market mentions in the minutes were bullish points.)

From 2016 to late 2018, GDP growth was positive and increasing. Not only was the US economy growing but it was also accelerating.

That sort of growth may eventually lead to inflation, but so far we don't see it in the data. The GDP growth rate has decreased in recent quarters, however, which may be a sign of an economy on the edge of a slowdown.

The rationale goes: if the Federal Reserve can encourage spending in advance of a recession, the impact will be lessened. Whether this is true is yet to be seen.

Was the July rate cut too premature?

In this author’s opinion, the decrease in interest rates was premature.

Recent expectations suggest that there may be another interest rate cut in the near future, potentially in the September 2019 meeting next week.

There has not been a significant increase in inflation recently. The S&P 500 in mid-September is still trading near it's all time high while and GDP growth continues to grow – most recently at a rate of 2% annually.

This 2% is higher than the GDP growth during 2016 when rates were beginning to increase.

So, premature. The only major reason that I saw for the timing of this interest rate decrease is the political pressure of one man’s Twitter account. It will be very interesting to see how the Federal Reserve’s logic continues to pivot going forward, but this interest rate cut gets a failing grade from me.

Cheers,

Cameron Daniels

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