This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics.
The Fed’s decision to lower its target range for the overnight federal funds rate range by 25 basis points was a mistake. It won’t have a significant effect on economic growth, it increased economic and policy uncertainty, and it raised concerns about the Fed’s independence.
Fed Chairman, Jerome Powell, attributed the cut to “trade policy developments” and “concerns about the strength of the global economy.” Like taxes, wars, a myriad of laws and regulations, technological innovations, the age distribution of the population, the population growth rate, productivity, and a host of other things, tariffs and global economic growth are part of the economy’s structure that the Fed has no control over.
More importantly, monetary policy cannot offset the effects of structural changes on economic growth: The 25-basis point rate cut will not cushion the effect of Trump’s trade war or slow global economic growth.
Economic growth during the current economic expansion, which is now the longest in the post-war period, has been uncharacteristically slow, averaging just 2.3% since the recession ended in 2009Q2. It’s important to note that this slow growth occurred in spite of the fact that the Ben Bernanke and the Janet Yellen Feds kept the policy rate at zero six and a half years into the economic expansion and engaged in a massive bond purchasing program.
I don’t know what is causing the slow growth, but the fact is the economy’s growth rate has trended downward since the late 1940s (see Economic Growth for more details). There is no definitive explanation for this trend, but it’s likely not due to a single cause. The downward trend in manufacturing output as the economy transitioned from a manufacturing economy to a service economy is likely a contributing factor. So too is the downward trend in output per man-hour of labor, the aging of the population, and the general decline of the population growth rate over the period.
Whatever the reasons, the fact that output growth was unresponsive to the Fed’s aggressive policy actions is compelling evidence that the current slow economic growth is due to structural changes that monetary policy cannot offset. When it comes to the economy’s long-term growth rate, the economy’s structure always trumps economic policy.
The failure of the Bernanke and Yellen Feds and other central banks to differentiate cyclical factors from structural factors is responsible for the low interest rate environment that has existed for more than a decade. Further cuts in the Fed’s or the ECB’s policy rates will not solve a structural problem. Broader economic reforms that can increase labor force participation and productivity are needed. However, before we can undertake such reforms, we must correctly diagnose the problem. Hence, many more resources need to be devoted to this effort.
The Fed’s rate cut also increased uncertainty.
Those who believe interest rates are too high or believe that aggressive rate cuts by the Fed could offset the deleterious effects of Trump’s trade war or slow global growth, wanted a larger cut—50 basis points or larger. They at least wanted the Fed to announce that this was the first in an extended series of rate cuts.
Financial markets signaled their disappointment with a 330-point drop in the Dow Jones Industrial Average. Positive news on employment and economic activity typically signal no action, so Fed watchers are having difficulty predicting the Fed’s next move: Will the Fed continue to reduce rates or stand pat?
The Fed’s unusual behavior also has renewed concerns about the Fed’s independence. Was the cut an insurance policy as Powell suggested or an attempt to appease the President while, at the same time, trying to appear independent? Powell and others who voted for the cut will have to work hard to convince a skeptical public that the cut was not an attempt to placate the President. The independence question may be cleared up at future meetings. If more rate cuts come while the labor market and economy remain strong, it will be clear that the Fed caved in to the President and the Fed’s independence may be no more.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
