Why Is the Fed Cutting Rates in a Good Economy?

So the economy is doing well, unemployment is low, and no big threats appear to be looming for the US. Yet the Federal Reserve’s policymaking panel on Wednesday is expected to lop short-term rates by a quarter percentage point. Why?

Insurance. That’s the take from Alan Greenspan, former Fed chairman, and other interest rate observers. When he ran the Fed, “we cut rates not because we thought that it highly probable that it would be necessary,” but just in case things go wrong, he told Bloomberg TV.

Indeed, as Fed head, Greenspan sliced the benchmark federal funds rate, which affects short-term rates for bank and other consumer lending, with three quarter-point cuts in 1994 and early 1996. That was to offset a perceived weakness in the US economy and abroad. Later, in 1998, he followed with another such trio of cuts, due to the Russian debt crisis and the collapse of hedge fund Long-Term Capital Management. 

Of course, that was a different era, when inflation and interest rates were higher: The Consumer Price Index was 2.5% in 1995 and 2.7%, versus 1.6% in 2019, as of June. Meanwhile, the federal funds rate was 6.0% before the 1995 reductions and 5.5% prior to the 1998 easing. Right now, the top of the Fed’s target range is 2.5%.

To critics like Jason Brady, CEO of Thornburg Investment Management, reducing rates now is “stupid.” Pointing to the low unemployment rate (3.7%) and other positive indicators, he asked, “What are we cutting for? We’re solving a problem that doesn’t exist.”

Fed Chairman Jerome Powell, in a speech in Paris two weeks ago, made much the same argument as Greenspan did, citing economic “uncertainties,” such as the US-China trade war, the mess of Britain’s exit from the European Union, and a global growth slowdown.

“They’re trying to extend” the US’s economic expansion, said Scott Colyer, CEO of Advisors Asset Management. “They don’t want to murder the economy,” referring to past instances where the Fed kept rates too high, only to invite a recession.

Certainly, the biggest cheerleader for Fed easing is President Donald Trump, who claimed that rate cuts would be “rocket fuel” for the economy. Trump obviously wants to ensure that the economy is doing well as he seeks reelection in 2020.

The Fed took short rates to near-zero during the 2008-09 financial crisis, and the Fed under Janet Yellen and then Powell sought to restore them to more normal levels. But after the Fed’s December 2018 hike, a lot of criticism arose that current conditions were too shaky to endure that.

According to the CME futures market, the odds are nonexistent that the Fed will do nothing on Wednesday: 75.5% favor a quarter-point cut, and 21.4% a half-point reduction.

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