Why the Federal Reserve Cut Interest Rates for the First Time Since the Crisis

The Federal Reserve on Wednesday cut interest rates for the first time in more than a decade, even as the economic expansion in the United States reaches record length, unemployment hovers at historic lows and consumers keep spending.

Uncertainty around global growth and persistently low inflation are behind the expected move, because both pose major threats to the health of the economy at a time when the central bank has limited ammunition to fight off a downturn. It is what’s called an “insurance cut” — one that central bankers are making to keep growth chugging along.

Inflation – a key indicator – has been too sluggish.

Inflation

+1.6%

Core P.C.E.

(excludes food

and energy)

2008-9 global

financial crisis

+1.6%

Core P.C.E.

(excludes food

and energy)

2008-9 global

financial crisis

+1.6%

Core P.C.E.

(excludes food

and energy)

2008-9 global

financial crisis

Annual change in personal consumption expenditures (P.C.E.) price index | Source: Bureau of Economic Analysis

The Fed’s main jobs are to maintain maximum employment and stable inflation. Officials have long aimed for 2 percent as the sweet spot for price gains. A little inflation is good, because it provides a buffer to keep prices from sinking during times of slow growth. Outright deflation is dangerous because it causes consumers to hoard cash, knowing that goods and services will be cheaper tomorrow.

The problem? Inflation hasn’t hit the goal sustainably since the Fed formally adopted it in 2012.

Stubbornly low inflation has also bumped up the risk that expectations for future inflation will drift lower.

That could create a self-fulfilling prophecy, because businesses expecting low inflation may set their prices accordingly.

While slow price gains might sound great, they can make it harder for employers to lift wages. Beyond that, the Fed’s policy interest rate incorporates price increases, so weak inflation leaves the Fed with less room to cut rates should the economy slump.

Policymakers want to get ahead of a global economic slowdown.

Concerns over the trajectory of the global economy have been building. The trade war, a slowdown in China and a weakening that spans many advanced economies might all be adding to the rising anxiety.

Global Economic Policy Uncertainty Index

Sept. 11, 2001

terrorist attacks

2008-9 global

financial crisis

Eurozone crises,

U.S. debt-ceiling crisis,

China leadership transition

European

immigration

crisis

Trump elected

U.S. president

Political turmoil in Brazil,

France and South Korea;

U.S. trade wars

Political turmoil in Brazil,

France and South Korea;

U.S. trade wars

Trump elected

U.S. president

Eurozone crises,

U.S. debt-ceiling crisis,

China leadership transition

2008-9 global

financial crisis

Sept. 11, 2001

terrorist attacks

European

immigration

crisis

Political turmoil in Brazil,

France and South Korea;

U.S. trade wars

Trump elected

U.S. president

Eurozone crises,

U.S. debt-ceiling crisis,

China leadership transition

2008-9 global

financial crisis

Sept. 11, 2001

terrorist attacks

European

immigration

crisis

Sept. 11, 2001

terrorist attacks

2008-9 global

financial crisis

Eurozone crises,

U.S. debt-ceiling crisis,

China leadership transition

European

immigration

crisis

Trump elected

U.S. president

Political turmoil in Brazil,

France and South Korea;

U.S. trade wars

A G.D.P.-weighted average of national indexes of the frequency of newspaper articles in each country that discuss economic policy uncertainty. | Source: Scott Baker (Northwestern Univ.), Nick Bloom (Stanford Univ.) and Steven Davis (Univ. of Chicago)

At a time when inflation is already low and interest rates do not have much room to fall, policymakers want to get ahead of any shocks that could disturb American growth.

Here’s what a rate cut could mean for you.

Manufacturing is one area where growing concerns could be bleeding into real economic activity. Indexes that track production across many advanced economies are either slowing or contracting.

While services make up a growing share of G.D.P., factory progress is a good economic warning signal: It slows down earlier than other industries when activity weakens. Fed officials have been watching the sector apprehensively.

Unemployment is often low right up until a recession, so it is a poor guide for Fed policymakers.

While inflation, global uncertainty and hints of slowing economic activity helped push the Fed to a cut, there are good reasons that officials are not yet predicting an all-out rate-cutting cycle that returns the policy setting to near-zero. Consumers are still spending, the labor market is growing and output remains strong.

But all of those data points respond to economic weakening with a delay.

Unemployment

(Includes unemployed and

people interested in working,

but not actively applying*)

(Includes unemployed and

people interested in working,

but not actively applying*)

(Includes unemployed and

people interested in working,

but not actively applying*)

(Includes unemployed and

people interested in working,

but not actively applying*)

*Total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percentage of the civilian labor force plus all persons marginally attached to the labor force. | Source: Bureau of Labor Statistics

The unemployment rate does not turn decisively higher until just before, and sometimes a few months after, the beginning of a recession. As a result, central bankers seem to think this is the time to get moving — waiting and watching can come later, once the economy has a little bit of added juice to fall back on.