Pressure for a Federal Reserve rate cut appears to be building in the press. Larry Summers spelled out the case in the Washington Post:
“First, markets currently expect rate cuts, so failure to deliver would be a negative surprise; it would have direct adverse effects and raise questions about whether the Fed is adequately sensitive to economic conditions….”
“Second, the Fed normally cuts rates by a cumulative 5 percentage points in response to recession, and with rates now below 2.5 percent there is nothing approaching that amount available….” Duh, the Fed tried to raise rates but traders protested!
“Third, and perhaps most important, unlike the normal situation where the benefits of supporting the economy need to be weighed against the risks of allowing inflation, we are now in a situation where the Fed needs to accelerate inflation to meet its 2 percent inflation target. Core inflation on the Fed’s preferred indicator has come in at 1.6 percent over the last…” [June 4, Washington Post (Real Daily Buzz)]
So, if traders in financial markets expect (want, and trade accordingly) a rate cut, the Fed must deliver? Yes, 2.5 percent is not much ammunition, but as the Fed tried to create some distance from 0, financial market participants were threatened by lower asset prices and “disciplined” the Fed, resulting in a cessation of the portfolio normalization and rate hike plans. And then there’s that “holy” 2 percent inflation goal that the Fed signed us up for without much justification. Summers strongly feels that they should be willing to achieve it, even if they have to over-stimulate a fully employed economy to create inflation and reduce the real incomes of workers. And if “core inflation” is the Fed’s preferred indicator, why did they set their policy goal in terms of the headline PCE? And this is “most important”? Others argue that cuts are needed at the short end to avoid the fearsome “inverted yield curve.” How about selling that $4 trillion-dollar portfolio and raising long term interest rates? There’s plenty of demand for those assets.
So, on June 4 at a Federal Reserve conference in Chicago, Chairman Powell gave a clear signal that the Fed was ready to cut rates if the economy “slowed.” The stock market went up 500 points. That’s how financial markets respond to Fed policy, and how “wealth” is created by Fed actions. On Main Street, the response was probably quite different. At a presentation to about 50 small business owners in Des Moines in April, owners were asked if a quarter point increase in interest rates would cause them to cancel an investment project at their firm. The response was a unanimous NO. Asked if a 25 basis point cut would induce them to reconsider a potential investment project, again NO. Asked if a 25 basis point difference in offered loan rates would induce them to change lenders, the answer was YES. Competition for loan customers is alive and well and the best terms win the customer. But quarter-point changes in interest rates are not driving investment decisions. More important is the expected return on an investment in profits and cash flow, and this depends on the economy.
Many observers feel that we cannot sustain 3 percent or better growth due to lower population growth, the aging of the population, reduced labor force growth, diversion of resources to unproductive activities (much due to artificially low interest rates and politics that favor transfer payments to infrastructure), and slower business investment (stock buybacks instead of productive investment). It is very clear that a shortage of workers to fill open positions is slowing growth for large and small firms alike.
Looking at the small business half of the economy, there is scant evidence that interest rates are too high. Although the Fed engineered “0” interest rates in financial markets after 2008, loans did not become easier to get on Main Street, a logical outcome of Fed policy. No bank can make a 10 year loan at rates lenders know will be higher, possibly much high in future years. Thus, Fed policy was contractionary in terms of supporting investment spending and remained so for years. Currently, complaints about credit availability are at historically low levels (Chart 1).
Chart 1
The percent of owners citing interest rates and credit availability as their single most important business problem is at 46 year record low levels and has been there for years. Chart 2 makes it clear that if owners have problems, they make it known.
Chart 2
Few owners complain that all of their credit needs have not been met, only 3 to 4 percent for the past few years. But when credit has been a problem, as it was in the late 70s and early 80s, owners complained in large numbers, but those days are a long time ago.
Chart 3
Thanks to Fed efforts to break inflation in the early 1980s (Chart 4) the cost of credit remained low for decades. The reason interest rates have trended down so dramatically is that the inflation premium in nominal interest rates has been dramatically reduced. Lenders must include in the loan interest rate protection from inflation over the loan period and the Fed’s successful war on inflation has substantially reduced the inflation premium.
Chart 4
So, at least on Main Street, in the real economy, there is scant evidence that interest rates are too high, that they are preventing real investment activity, or that credit is not available at current rates. Indeed, most if not all of the anxiety is coming from Wall Street, where billion dollar bets depend on whether interest rates go up or down a few basis points. The response of the stock market to Chairman Powell’s announcement shows who is really concerned about interest rates and who thinks they should be cut.
