The following is an excerpt from a recent Market Comment featured in The Felder Report Premium.
The Fed is going to cut the funds rate today not because the economic data justify it or even because they want to try to prop up asset prices in supporting the “wealth effect.” Jerome Powell & Co. will cut rates for one reason and one reason only: because the Fed is petrified of the “zero lower bound” or ZLB, as they call it.
In a pair of speeches recently given by Federal Reserve Chairman Jerome Powell and New York Fed president, John Williams, this was made abundantly clear. In Powell’s speech, titled “Monetary Policy in the Post-Crisis Era,” the thing that stood out to me was his framing of the current challenges facing the central bank:
Trend inflation, productivity, and interest rates were declining well before the crisis. But, for monetary policymakers in that era, the threat of high inflation felt proximate, the hard-fought battle to control high inflation having been just recently won. Technological progress seemed likely to continue to sustain rapid increases in productivity—an outcome we continue to await. And the effective lower bound for interest rates was mainly a theoretical concern, except of course in Japan. The changes to the macroeconomic environment may have been in train earlier, but the crisis seems to have accelerated the process. The world in which policymakers are now operating is discretely different in important ways from the one before the Great Recession.
In other words, Powell think central bankers have been fighting inflationary impulses for far too long as a result of their painful memories of the inflationary episode 40 or so years ago. The challenge facing the central bank today is just the opposite; inflation and interest rates have fallen too low leaving them with very little firepower to deal with the next recession.
Those at the Fed are no doubt looking at the possibility of recession and then looking at their tools to deal with it and finding them wanting. In recessions past, the Fed has typically cut 500 basis points or so. Today, this would put the Fed Funds rate deep into negative territory, far deeper than anywhere else in the world. And as Bloomberg reported recently, the history of negative rates has not quite validated their use:
Europe’s unconventional experiment with negative interest rates to spur economic growth and inflation is looking like a trap. Five years into what was supposed to have been a temporary shot in the arm for the euro area, the European Central Bank still hasn’t achieved its goals and may be about to push rates even lower. Japan, Switzerland, Sweden and Denmark have also stepped over the zero bound, once seen as the lower limit for monetary policy. With global economic growth slowing, negative rates are staying around. But the longer they persist, the louder the criticism grows. They’re blamed for weakening banks, expropriating savers, keeping dying companies on life support, and fueling an unsustainable surge in corporate debt and asset prices.
Certainly, those at the Fed appreciate these issues and are thus loathe to follow in the footsteps of their counterparts at the ECB. So how do they avoid such a fate? Enter John Williams who delivered a speech of his own titled, “Living Life Near the ZLB,” in which he lays out his prescription for inoculating the United States from just such an outcome:
The ZLB has been a topic of study for nearly two decades. But recent history and the outlook for the longer-term future, make it more relevant than ever. Low inflation expectations, very low r-star, and slower growth all point to a challenging world where policymakers need to make the best use of the tools at their disposal to achieve their goals of strong economies and price stability. The key lessons from this research hold today and in the future. First, take swift action when faced with adverse economic conditions. Second, keep interest rates lower for longer. And third, adapt monetary policy strategies to succeed in the context of low r-star and the ZLB. These actions, taken together, should vaccinate the economy and protect it from the more insidious disease of too low inflation.
There is much to infer from this. First, and most obvious, is that the Fed views “too low inflation” as an “insidious disease” they must strive to cure us from. Second is that the group is now hell-bent on raising inflation expectations. In those efforts, they may be willing to pursue a little shock and awe with monetary policy (50 bps cut?), hold interest rates lower than can be justified by the economic data alone and, finally, communicate that they will tolerate or even encourage inflation to “run hot” for an extended period of time.
For a long time now, investors have sworn by the saying, “don’t fight the Fed.” And while disinflation was the central bank’s modus operandi, it made sense to buy financial assets that would benefit. Ironically, with the Fed now determined to boost inflation at all costs, investors piling into both the stock and bond markets don’t seem to appreciate they are picking a fight with the most powerful monetary authority on the planet.
