Navigating the Trade-Off of the Federal Interest Rate Cuts

For the first time in over a 9 month period, the Federal Reserve System, i.e., the Central Bank of the United States of America, announced its decision to make a slight cut in the interest rates by 25 basis points, bringing it down from a 4.25 to 4.50 percent range to a new target of 4.00 to 4.25 percent. Before exploring the essence of why such cuts were made and their possible implications, let understand the operations of the Federal Reserve System.

The Fed works in a “Dual Mandate”, i.e., moving the economy toward maximum employment and stable prices. It makes informed decisions on how to make use of its monetary policy which affects the financial lives of all Americans by raising or lowering the federal funds rate, an interest rate for overnight borrowing by banks. In simple terms, if the target range is lowered, representing an “ease” of the monetary policy, it would lower the short term interest rates in the financial markets and is

usually done when the economy is sluggish or the inflation is too low. On the contrary, raising the target range would represent a “tightening” of the monetary policy as it raises the interest rate and is usually done at a time when the inflation rate is high.

Describing the move as “risk management”, Jerome H. Powell, the Fed Chair, implied that this decision was to give a boost to the economy rather than addressing the economic downturns that have already taken place. Officials also signalled a possibility of further cuts to address the rising risks in the labour market, bringing the Fed’s key benchmark to a new target range of 3.5 to 3.75 percent.

Source: Bloomberg

But what could be the possible economic downturns being faced by the United States?

The list that primarily influenced such a decision consists of:

• The weakened labour market, indicative due to a slowdown in the growth of jobs due to tighter immigration policies and while still historically low, an “edged up” unemployment rate. Even in a press conference after the announcement of the cuts, Mr. Powell expressed the decline in both supply and demand of the labour force being “unusual”, attributed to the tariffs and the immigration policy.

• A growing uncertainty in the geopolitical atmosphere due to higher tariffs on the U.S.’s trading partners, basically remaking the global trading system, leading to trade wars.

  
  

However, here is where the contradiction occurs, as the Fed now faces a dilemma, one created by the very dual mandate it abides by, i.e., maximum employment and stable prices (inflation rate at 2 percent). The cuts it made, made with the labour market in mind, overlook the growing prices, as the US consumer price index rose to 2.9 percent in August, with officials expecting it to climb up to 3 percent.

In conclusion, on the surface level, this is a great change, as it actively lowers the borrowing costs for the American household, but, if further cuts were to be introduced, as mentioned by some officials, it would lead to an increase in the consumer price index which would in turn increase the Personal Consumption Expenditure (PCE) in the long run.

Written by:

Aryan Joshi