By deciding to cut interest rates, the Federal Reserve has positioned itself as a shield, protecting the U.S. economy from its own government’s worst instincts. But it may have also set itself up to be President Donald Trump’s enabler.
The Fed’s quarter-percentage-point rate cut announced Wednesday – lowering the federal funds rate to a range of 2 per cent to 2.25 per cent, its first easing since the financial crisis in 2008 – is decidedly not something the U.S. economy is screaming for right now. It’s not even whispering for it. Not when the economy is already operating at full capacity (if not over capacity), with growth in the second quarter, at 2.1 per cent, high enough to squeeze that capacity a little more and unemployment near 50-year lows.
Sure, Fed chairman Jerome Powell talked in his news conference about the Fed’s worries that inflation is slightly below its target. But against that economic backdrop, it wasn’t very convincing. Inflation may be part of the Fed’s justification for this move, but it’s not the motivation.
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No, this rate cut is chiefly about playing defence against the mounting fears that Mr. Trump’s self-inflicted trade war with China could blow up in his face, taking the U.S. economy down with it. Given the damage to global growth already inflicted by the U.S.-China dispute, the Trump administration’s protectionist policies and the lack of visibility on any resolution, the Fed decided to take out some “insurance,” as many Fed watchers have described this, against the risk that the trade dispute could go spinning seriously off the rails. (Mr. Powell adopted the word himself Wednesday, acknowledging that, “there is an insurance aspect” to the rate cut.)
When you’re dealing with one of the most unpredictable, impulsive presidents in history, “better safe than sorry” seems like a reasonable way to go.
But the danger in turning pre-emptive on trade-policy risks is the message it sends to that same mercurial President. The Fed has handed Mr. Trump a licence to walk his trade-policy tightrope even more recklessly – assured, now, the Fed is there with the safety net.
“It might introduce a bigger moral hazard problem, if it emboldens the Trump administration to pursue a little more unstable trade and other policies,” Bank of Nova Scotia economist Derek Holt said in a recent interview. “He feels like he has a security blanket over him provided by the Fed.”
With the precedent now set, The Trump administration, as well as the financial markets, might expect the Fed to meet any escalation of the trade war with further rate cuts.
“Are we going down a dangerous spiral of easing, emboldening trade policy, further easing? [There’s] a risk of being quite destabilizing to the outlook if we keep going down that path.”
One important consideration in interpreting the Fed cut is whether this is a small dose of preventive medicine or the start of a much deeper easing phase. The latter would suggest the Fed had bigger fish to fry than hedging the economy against rogue trade policies – that it felt a recession coming on.
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But Mr. Powell was crystal clear this isn’t what the Fed has on its mind. He described the cut as a “mid-cycle adjustment,” stressing “it’s not the beginning of a long series of rate cuts.” He left little doubt this is just a brief rewind in an otherwise upward-moving rate trend – not an all-out reversal of course.
It’s notable the Fed itself is split on how to deal with Mr. Trump’s policies. (Join the club.) Two of the 10 voting members on its rate-setting committee (Kansas City Fed president Esther George and Boston Fed president Eric Rosengren) voted against cutting. The lack of unanimity suggests there may not be enough support within the Fed to cut much deeper.
That doesn’t mean the Fed will stop at a single rate cut. But the last time the members of the committee were asked, in mid-June, their rate outlook suggested one or two quarter-point cuts would be the extent of it. And nothing the Fed said Wednesday suggested it believes the downside risks to its outlook have increased since then. Perhaps, then, one more cut – likely in the fall – should give the Fed all the insurance it needs.
Until, that is, Mr. Trump turns up the heat on China or whomever else gets in his protectionist sights – and moves the yardsticks again for the Fed. It has shown it is willing to change its stand in the face of policy risk. The danger now is how often it will be forced to do so.