Policymakers at the U.S. Federal Reserve are virtually certain to cut benchmark interest rates another quarter point this week—to 1.5 to 1.75%—but officials will be at pains to emphasize this is it until there is tangible evidence of an economic downturn.
Fed Chairman Jerome Powell has insisted that the latest round of cuts is a mid-cycle adjustment, not the start of a downward path in rates to accommodate an economic slowdown. Likewise, he's affirmed that renewed Fed purchases of bonds are not a new round of quantitative easing, but rather an adjustment to correct a shortage of bank reserves.
Historically, a mid-cycle adjustment, such as those seen in 1995 and 1998, can be 0.75 points, which is the total of what would be three rate cuts since July. Building a buffer of bank reserves is legitimate in the wake of money market turmoil when suddenly there weren’t enough.
Still, essentially, the Fed has made not one, but two mistakes. First, it set itself on a path to raise rates in 2018, mistakenly thinking economic growth would push inflation up. And it kept on that path in the face of all evidence to the contrary—inflation was not going up despite low unemployment. Instead, the labor market continued to expand.
The second mistake was to willy-nilly start winding down its balance sheet after pumping it up with quantitative easing. In the process, it cut bank reserves in half, to $1.4 trillion from $2.8 trillion.
Turns out that's not nearly enough to cover overnight lending needs at peak periods like the one that occurred September 16-17. Economists want the U.S. central bank to add $400 billion to bank reserves and grow that in line with the economy.
Then there's U.S. President Donald Trump who's angry with the Fed because he wants them to turbo-charge the economy with cheap credit. Of course, investors have a right to be angry because the Fed keeps making big mistakes.
If policy makers are in fact able to wipe the slate clean on both fronts by reducing rates once more and restoring bank reserves to a sufficient level, can we sit back and relax? Perhaps.
But this inability to settle on appropriate policy has not contributed to investor confidence in the Fed under Powell’s guidance. This loss of credibility may be its biggest problem.
Powell needs to assert his leadership. There are members of the Federal Open Market Committee (FOMC) that question the need for further interest rate cuts in spite of trade tensions and some indications of economic softness. Maybe they could sit on their hands for once and be satisfied with forward guidance that there will be no further cuts in the immediate future. It would be so much more credible if this rate cut could emerge with no formal dissents.
Investors can help, too. Markets should take Powell at his word if he finally does have it right. Sure, even lower rates would be nice, but this should really be enough for a mid-cycle adjustment. Yes, asset purchases are asset purchases and a bigger Fed balance sheet is by definition accommodative. But this, too, is a fine-tuning of monetary policy, not a change of course.