As expected, the US Federal Reserve Bank cut interest rates a quarter of a point today. The justification was “implications of global developments” on the economy, as well as muted inflation. But it’s not clear what this rate cut will achieve. Low rates don’t appear to be doing much good for the economy, at least not lately. Despite a series of rate cuts in 2019, business investment is down, unemployment is not any lower, and inflation has not increased.
Mario Draghi, who is retiring as head of the European Central Bank, said in his outgoing speech the monetary policy of rate cuts may not have the same power they once did:
Today, we are in a situation where low interest rates are not delivering the same degree of stimulus as in the past, because the rate of return on investment in the economy has fallen. Monetary policy can still achieve its objective, but it can do so faster and with fewer side effects if fiscal policies are aligned with it.”
Economists long argued that monetary policy doesn’t have much impact on the real economy, but it was always thought central banks could boost demand in the short run, and by extension inflation, by cutting its key interest rates. Lower rates not only made borrowing cheaper, but a central bank’s involvement adds certainty and stability to markets because investors like to believe someone has some order and control. But what if the Fed doesn’t have any control?
Most industrial countries, despite low rates, are falling short of their inflation targets. Normally, central banks rely on conventional tools—like buying or selling short-term bonds to alter the Federal Funds rate, which is presumed to encourage or discourage bank lending—to generate more economic activity and spark or curb inflation. But those rate cuts don’t have the same oomph they once did. When interest rates are 7%, cutting them to 5% has more power than going from 1.75% to 1.5%. Lower rates are not the only problem, however. It could be monetary policy is more effective at boosting demand during a recession or fighting inflation, and just isn’t suited for an already growing, low-inflation economy.
There is also the increasingly international nature of money to blame. One of the ways monetary policy is supposed to work is that by manipulating the Fed Funds rate, it is presumed to influence other key interest rates, like long long-term rates and mortgages which ripple through the economy. But in a more global market where rates are determined by more factors, including foreign buyers, the Fed Funds rate may be less effective.
Central bankers justify rate cuts because they can act as an insurance policy to keep the economy out of a damaging recession. But that assumes rate cuts can deter a recession and it’s not clear they can. When the next recession comes it will probably stem from an external shock, like a trade war, and a pre-emptive quarter-point rate cut to ease markets can’t do much to alleviate the economic damage of a huge economic cataclysm. Cutting rates now also leaves policy makers with even less room to cut if a negative shock does occur.
Some Wall Street analysts argue recent rate cuts had some impact, citing an uptick in consumer spending. But it is hard to know the counterfactual—would consumers be spending more even it rates stayed the same? Meanwhile, manufacturing data remains weak and economic growth has started to slow. That bankers believe the rate cuts are important is telling, because it suggests monetary policy still shapes investors expectations and possibly their behavior. In this case, a rate cut may not directly impact the economy, but it does promote confidence, which could help keep it from crashing.
There are also other alternatives to rate cuts. During the financial crisis central banks expanded their arsenal, and bought long-term bonds and mortgage backed securities (a policy called quantitative easing) and started paying interest on reserves. The ECB is still buying long-term bonds, Australia is considering it, and the US still has a large balance sheet from its rounds of QE. But former Bank of India Governor Raghuram Rajan questions if any of it was effective, either. He argues these unconventional measures stabilized financial markets during the crisis, and even if they didn’t have a direct impact on markets, they created expectations that central banks were in control and that these expectations can be self fulfilling and create market stability.
Monetary policy may not have the power it once did, but, at the very least, rate cuts and QE are meant to influence expectations and calm markets and they may achieve that. If policy doesn’t have a real effect and its only benefit is making markets believe someone is in control, even if they are not, eventually markets will catch on, and the central bankers may need to find new levers to pull.