Why the Fed Cuts the Rate?

The Fed is expected to cut the Federal Funds Rate (FFR) by 0.25% tomorrow. This rate cut is of special meaning because it will be the first Fed cut since 2009. The common suggested reason for the cut is to proactively provide liquidity for the market to save the coming recession. However, the US economy is performing almost unprecedentedly well. The index of the stock market is record-breaking, the unemployment rate is so low that it is approaching full employment (natural unemployment rate), the GDP annual growth rates in the past 4 quarters are 3.1%, 2.5%, 2.7%, 2.3%, which are reasonably high and quite steady since 2010. (Figure 1)

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Figure 1 US GDP Annual Growth Rates 2009–2019. Source: Trading Economics

Of course, one may argue that the Fed can be pro-active, instead of reactive. However, from the past patterns, the Fed’s decisions on rate changes were reactive, rather than pro-active, as far as the stock market performance is compared with (as shown in Figure 2). Why would it change this time requires more justifications for this argument.

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Figure 2 The Association between the Fed’s Rate Changes and the Stock Price Index, 1999–2019. Source: Dohmen (2019)

The positive correlation between the Fed’s rate cuts and the stock price plummets in the past 2 decades, and the short-term leveling off of the Fed’s rate before the cut, show that the Fed was responding to the market changes. (Though correlation does not imply causality, it doesn’t make logical sense that the Fed cut the rate to trigger the stock price plummet.)

Since the Fed’s cut is responsive and gradual in nature, and it takes time for the market to reflect the effects of the Fed’s cut, thus it took 13 cuts during 2000–2003, and 10 cuts during 2007–2008 to stop the -51% and -58% stock price plummets. Then, the Fed would keep the rate level off for a period of time until the market signal for a rate hike emerged. The signal is, in general, the inflation rate (general price level change). It explains why the market is now expecting a series of rate cuts in the coming months. Yet, it only allows 10 cuts of 0.25% each, because the current rate is just 2.5%.

One of the major objectives of the Fed is to channel the inflation rate to 2%, which is likely to be one of the leading indicators of the Fed’s decision on the FFR. In fact, referring to the US inflation rates in the past 3 years (Figure 3), one can easily find that the inflation rates have been increasing from about 1% to about 3% peak since the 2016 Fed’s rate hikes. However, the inflation rate shows a decreasing trend in recent months and the latest inflation rate in June 2019 was just 1.6%. The Fed is taking action in response to the change of the inflation rate.

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Figure 3 US Inflation Rates, 2014–2019. Source: Trading Economics

Considering the real rate rather than the nominal rate, you can find that the real rate (nominal rate minus inflation rate) is negative in 2016 and 2018, but now the real rate becomes positive in 2019. Together with some other leading indicators, such as the PMIs are also dropping below 50 (indicating a contracting production), the Fed’s rate cut is a reactive action upon the slowdown.

Why a rate cut can save a recession?

Theoretically, a short-term interest rate cut would urge more people to borrow more debts (lower cost of finance), and to save less (lower benefit of saving).

Empirically, there is ample evidence supporting this theory. For example, Alan Greenspan (2014), the former Chairman of the Fed, has shown evidence in the US. First, he showed that “… money velocity can be explained largely by the level of short-term interest rates. The higher the interest rate, the more likely people are to hold income-earning assets in lieu of cash, thereby reducing M2 and raising money velocity… money supply is by far the dominant determinant of price over the long run.” (pp.279–280). (Figure 4)

In other words, the Fed believes that the short-term interest rate determines money supply, and the money supply determines inflation. If their target is to keep the inflation rate at 2%, then the coming rate cut is clearly a response to the recent downward trend of the US inflation rate.

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Figure 4 Money Supply is the Dominant Determinant of Inflation in the long run, evidence in the US. Source: Greenspan (2014)

References

Dohmen, B. (2019) The Fed Is Going To Cut Rates: Be Careful What You Wish For, Forbes, July 27. https://www.forbes.com/sites/investor/2019/07/27/the-fed-is-going-to-cut-rates-be-careful-what-you-wish-for/#2e5d49fd60b2

Greenspan, A. (2014) The Map and the Territory 2.0 — Risk, Human Nature, and the Future of Forecasting (Updated and Expanded), New York: Penguin Book.

Written by

ecyY is the Founder of Real Estate Development and Building Research & Information Centre REDBRIC

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