The Federal Open Market Committee (FOMC) meeting on July 31, 2019, marked a historic day in the financial markets. It was the first time since 2008 that the Federal Reserve cut interest rates. The 25-basis-point rate cut was described by Fed Chair Jerome Powell as “intended to ensure against downside risks from weak global growth and trade tensions.” Markets sold off dramatically after the policy announcement. Many on Wall Street had been expecting a 50-basis-point rate cut. I’ll share some technical economic data below that corroborates the Fed’s more conservative move.
Insurance is never cheap, so who pays for this “insurance” rate cut? Hard-working savers. Rate cuts are a forced tax on money in the bank. At the aggregate level, this means retirement savings for all are pushed out a little further. Alternatively, we are nudged to take more unwanted investment risks to make up for reduced future savings. Rate cuts are extremely expensive and thus always a very difficult decision for the Fed to make.
Was a rate cut really necessary? Time will tell, but recent economic developments support this tactical move. The overnight Federal Funds rate, down a quarter and ranging now between 2.00 and 2.25, is the primary policy tool the FOMC uses to influence economic growth. The rate cut trickles down through real economic activity, impacting two of the Fed’s key performance indicators: maximum employment and price stability. Both variables are the Fed’s mandated objectives from Congress. Let us take a closer look at the data for each and contrast them with last year.
First, aggregate employment numbers look fantastic on the surface. The unemployment rate continues to hold steadily below 4% thus far in 2019. Job creation has been moderate in 2019, with the U.S. economy creating an average of 172,000 jobs every month. While these numbers suggest positive news, an average of 172,000 jobs a month is about 22% below the average over the same period in 2018. I believe the rate cut was designed to jolt economic activity just enough to stop the slide and lift employment numbers. The need for more rate cuts will likely increase if job creation continues to trend downward. In fact, at the time of writing this, the market has already priced another rate cute with a probability of 99.6% at the upcoming September FOMC meeting.
Second, even as the economy continues to grow, inflation, as measured by the Personal Consumption Expenditures (PCE) index, has averaged around 1.5% in 2019. The PCE index in 2019 continues to trend lower than the 2.0% levels reached in 2018. The Fed closely monitors monthly PCE data, with a target of around 2.0% as part of its price stability mandate. The lack of price inflation in 2019, despite decent year-over-year retail sales data, suggests the Fed has room to reduce interest rates with little impact on long-term price stability.