Does the Fed Matter Any More?
Almost everyone thinks the Fed will cut rates next month because job growth is weakening. But here’s a question: Will a rate cut really help?
That may seem like a strange thing to ask. Central banks raise interest rates to control inflation and cut them to stimulate demand, which in turn creates jobs. It’s a very familiar process, played out many times around the world.
Let’s consider how this could happen, if it does.
Right now, the main issue isn’t that employers are firing people. They’ve just slowed or stopped hiring.
This is still a problem, though. We need new jobs for people just entering the labor force. Or re-entering it, as many retirees have to do when inflation raises their living costs.
Suppose the Fed tries to address this by reducing rates. What would happen?
First, recognize that the Fed only controls the rate it charges banks, or banks charge each other. A rate cut may not trickle down to customers.
But assume it does. How many employers that are not presently in hiring mode will change gears if they can borrow at 6% instead of 7%?
In other words, what is the barrier against expanded hiring? Is it cost of capital or something else? What new economic activity would occur if rates were lower?
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Surveys like NFIB find the main business problem is an inability to find quality workers. A rate cut is unlikely to change this.
Ah, you say, but it’s not just the employers. Lower rates would also reduce the cost of consumer loans. People who can’t afford a new car or home or washing machine might suddenly start buying if credit costs are lower. That would generate new jobs.
Or not. Lower financing costs don’t help much when the price of the product rises due to tariffs, inflation or anything else. You end up paying the same net cost and maybe more.
That’s exactly what happens when mortgage rates fall. Unless the supply of homes for sale also expands, sellers simply raise their asking prices to whatever the market will bear.
It’s also not clear a rate cut at the short end would produce lower rates for long-term loans like mortgages. It didn’t when the Fed cut rates last year. Mortgage rates went up because lenders perceived (correctly, it turned out) lower short-term rates would mean higher inflation risk.
Rate cuts have other effects, too.
In 2022 savers, including many retirees, began getting non-zero yield on their cash for the first time in many years. This is one reason consumer spending has been surprisingly resilient against inflation.
This means a rate cut would also be an income cut for people who live off their savings. To the extent their spending falls, it would probably mean fewer jobs, not more.
Put all that together and it sure looks like lower rates won’t help the labor market much. But that doesn’t mean a cut would have no benefit at all. It would help borrowers whose debt is mostly tied to short-term rates.
The largest such borrower, by far, is the federal government. This year’s interest bill for our huge public debt will be almost a trillion dollars. Reducing that expense would help reduce the debt (if we don’t use the savings for new spending or tax cuts), helping everyone in the long run.
But there’s a problem. The Federal Reserve operates under a legal mandate that requires it to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."
Helping balance the budget isn’t part of the Fed’s mandate. It may actually conflict with the Fed’s mandate if it raises inflation and long-term interest rates.
Fortunately, we have non-emotional, non-political tools to balance all these considerations. The well-known “Taylor Rule,” for example, considers inflation, unemployment and other economic data to identify an optimal Federal Funds rate.
The Federal Reserve Bank of Atlanta has a handy Taylor Rule calculator that crunches the numbers for you. It gives alternative scenarios based on different inputs. Right now, they range from 4.26% to 5.45%.
The actual Federal Funds rate stands at 4.33%. So, under the Taylor Rule, rates don’t look too high and might even be too low.
Economists also have something called R* (pronounced “R-star”), a theoretical “neutral” interest rate at which Fed policy is neither restrictive nor stimulative.
Depending on how you calculate, R* is roughly 1 percentage point below the current level. Moving rates down toward R* would mean a turn toward stimulation.
That could be the right move if growth is really weakening – or a terrible mistake if inflation is still brewing.
But in the bigger picture, I’m still not sure the Fed’s answer will matter. Our problems are deeper than interest rates being a little too high or low.
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See you at the top,
Patrick Watson
@PatrickW
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