WASHINGTON: On Wednesday, as most investors expected, the Federal Reserve left interest rates unchanged for now but said the case for cuts later in the year is stronger than before. That judgment looks reasonable, all things considered.
Right now, the US economy is at or close to full employment, growing at a satisfactory rate, with inflation close to the Fed’s target of 2%. There’s little sign of significant slack in the labour market, so extra demand would be more likely to produce inflationary pressure rather than more jobs and higher output. That’s the case for standing pat.
Yet the Fed is also right to note that the downside risks have increased since its last review. Though Chairman Jerome Powell can’t say it straight out, the main reason is President Trump’s new threats to escalate trade disputes with China, Mexico, and Europe. Even if in the end the US doesn’t raise its tariffs – and the risk has seemed to subside in the past few days – the constant protectionist posturing acts as a tax on investment, especially in manufacturing, which has come to rely heavily on international supply chains.
In short, the president’s militancy on trade is capable of depressing confidence and demand enough to warrant a shift in Fed policy. Some Fed officials already think that one or two quarter-point cuts will be needed between now and the end of the year. Trump would doubtless hail such cuts as a victory: He’s been pressing the idea for months. But it would be a strange kind of victory if the Fed had to step in because the White House had sabotaged the expansion.
Trump’s manoeuvring on trade, together with investors’ obsession over quarter-point changes in interest rates and fluctuations in the phrasing of Fed statements, is unfortunate in another way. It distracts from big, looming questions on the future of US monetary policy – issues that still aren’t getting the attention they deserve.
Powell touched on this at yesterday’s press conference. Because of demographic changes, long-term declines in the cost of capital goods, and other deep-seated economic shifts, the US might have to contend with a new era of persistently low interest rates. This means that the “effective lower bound” (zero, roughly speaking) is never that far away – rendering monetary policy much less potent as a recession-fighting tool than it used to be.
The Fed is in the midst of a review of the options for policy in this new environment. The discussion up to now has been narrow and too low-profile, focusing for instance on tweaking the central bank’s procedures to improve the credibility of its forward guidance. Bolder thinking that this will be needed, and it cannot be confined to the Fed and its penumbra of monetary-policy technicians. Options as radical as adopting a higher inflation target, or blurring the boundary between fiscal policy and monetary policy, will need to be weighed.
The Fed’s decision this week was correct, but the economy is changing and monetary policy is falling behind. Short-term distractions and self-inflicted injuries aren’t helping. These new questions need answers – preferably before the next recession.