[written with Mark Zandi, chief economist of Moody’s Analytics]
This is a post about one-quarter of one percent.
That’s the amount by which the Federal Reserve is expected to reduce the federal funds rate, the key interest rate they control, when they meet at the end of this month. If that sounds like too small a change to get worked up about, we assure you, Fed rate changes can be a big deal, especially when they change direction. The central bank had been steadily raising rates over the past several years, and only just a few months ago was predicting further rate increases this year and next.
The decision to cut rates has become a bit more complicated, as last week’s solid jobs report weakened the case for the cut. Why add interest-rate stimulus to an economy that’s already going strong?
Moreover, this month, the current economic expansion—meaning the time between the end of the last recession and the start of the next one—became the longest on record. Based on growth rates compared to past downturns, it has been more long than strong, but the unemployment rate has been hovering near 50-year lows, and the combination of abundant job creation, low inflation, and better wages have powered that ever-acquisitive creature, the American consumer. Given that our GDP is 70 percent consumer spending—in Europe, it’s 55 percent; in China, it’s 40 percent—the strong labor market can go a long way toward sustaining the expansion.
So, again, why cut rates?
First, for all the July fireworks around last week’s strong job gains (224,000 jobs created, compared to 72,000 the month before), the job market is slowing. The monthly data are noisy, so to get at the underlying trend, you’ve got to average out the noise. Over the first half of this year, employers have added about 170,000 jobs per month. That’s a healthy clip, no doubt, but last year the monthly gain was 235,000.
This slowdown could intensify, courtesy of President Trump’s trade war. While the President has ostensibly agreed to a truce in the war with China – freezing the current tariffs and relaxing restrictions on the Chinese tech-company Huawei – this will do little to reduce the uncertainty and resulting angst of American companies doing business with the rest of the world. In fact, the usual pattern has been periods of truce followed by more chaos, demands, threats, and, in some cases, actions in the form of more or higher tariffs.
This pattern has left businesses demonstrably nervous. Moody’s Analytics measure of global business confidence is as weak as it has been since the economy began to recover from the financial crisis a decade ago. Similarly, businesses’ expectations as to how well they think they’ll be doing later this year have slid to where they were just prior to the financial crisis. Two-thirds of respondents to Duke University’s quarterly survey of company CFOs say a recession is likely by the end of 2020; Morgan Stanley’s business conditions index, designed to capture turning points in the economy, suffered its largest one-month decline on record in May.
As you might expect, such sentiments tend to correspond to weak investment plans. Despite the tax cuts corporations got beginning last year, and contrary to the predictions of advocates for those cuts, investment has flat lined over the past year.
If these sentiments and weak investment behavior persist, eventually businesses will cut back on their hiring. If so, and unemployment rises, even a little bit, and even from very low levels, recession becomes a real possibility. That’s because those consumers powering the economy will quickly sense the weakening job market and turn more cautious in their spending. Businesses will see this and pull-back further on jobs. The virtuous economic cycle that characterizes the economy today, will turn into a vicious one.
A one-quarter percent Fed rate cut at their late July meeting can help forestall this possibility. A small cut is a way by which monetary policy takes out an insurance policy against the impact of the trade war, or any of a litany of other threats from Brexit to another government shutdown.
What’s the argument against a rate cut? It’s that the labor market is already at or near full employment and any extra stimulus might push unemployment down even further, risking overheating and higher inflation.
But even if the aforementioned pressures fade and the expansion continues apace, the Fed has plenty of time and firepower to respond to price pressures. Inflation is low, arguably too low. The Fed wants inflation to hover around 2 percent per year. It’s fine for price growth to be a bit below this target some of the time, but only if it is also above the target other times, so that it averages out to be 2 percent over time. But since the last recession, inflation has never sustainably reached the target, and this undershoot is starting to show up in people’s expectations about the future course of price growth. If these diminished expectations get cemented, it could take a long time to get inflation back on track. Just ask the Japanese, as they’ve been trying for several decades.
No one know when the next recession will occur. But we are confident that growth is slowing, and there are serious threats, mostly of our own making, to the expansion. This warrants a rate cut when the Fed meets in a few weeks.