On September 18, 2019, the Federal Reserve decided to cut the interest rate by 0.25%. This has been the second rate cut of the year. Let me illustrate what is going on with an analogy. You can think of this decade long bull market as a party, and the interest rates as the punch bowl that keeps the party going. When the Federal Reserve raises interest rates, it is slowly limiting the supply of punch bowl. On the other hand, when the Federal Reserve lowers interest rates, it is slowly increasing the supply of punch so that more people can enjoy the party. The goal of the Federal Reserve is to take the punch bowl away before everyone at the party gets a hangover. Furthermore, the Fed re-introduces the punch bowl once it sees that the party has died down. To sum it up, by controlling the supply of punch in the punch bowl, the Fed keeps the party going while making sure that the least number of people get a hangover. The Fed dictates when people need to party and when they need to sober up. So, why is the Federal Reserve cutting interest rates? In other words, why is the Fed re-introducing the punch bowl into this decade long party? Are there any problems with the US Economy? In this week’s blog post, I will talk about the US Economy, Federal Reserve, and Interest Rates. Let’s dive in.
The Federal Reserve has 2 objectives: maximum employment and stable prices. The Fed makes the decisions associated with interest rates based on facts and objective analysis. As Jay Powell, Federal Reserve chairman, pointed out on September 18, 2019 that the US Economy has continued to perform well and that the United States is in the 11th year of its economic expansion. The economy grew at 2.5% pace during the first half of 2019. He said that household spending, supported by strong job market, rising income, and solid consumer confidence has been the key driver of this growth. On the other hand, business investments and exports have weakened as the US manufacturing output falls. The Federal Reserve thinks that this weakening is due to slower growth abroad (Europe and China) and the recent trade policy developments (uncertainty about business investments). The Fed also foresees geopolitical risks, such as Brexit, which remain unresolved. Chairman Powell said that job market remains strong, the unemployment rates have been at a 50 year low, and job gains have remained solid. Furthermore, wages have been rising for lower paying jobs. The Federal Reserve expects the job market to remain strong. At this point, you might be thinking to yourself that the United States Economy seems do be doing great. Why is the Federal Reserve cutting interest rates i.e. introducing more punch to this long extended party? Well, it all comes down to inflation. (You can listen to Chairman Powell’s speech here.)
Inflation continues to run below the Fed’s 2% objective over the past 12 months through July. Powell stated that inflationary pressure clearly remain muted. You might be thinking that isn’t inflation a bad thing? Isn’t it good that we don’t have inflation? Well, you are partially correct. You do not want the inflation to be out of the roof high, but you do want a little inflation. Having a little inflation incentivizes people to spend their money, which promotes economic growth. By not having inflation, people are incentivized to hold onto their money because they will be able to buy more with that money in the future. As people stop spending, the economy stops growing. In short, if you know that prices of goods are going to increase tomorrow (inflation), you will spend your money by buying that good today (helping the economy grow). On the other hand, if you know the prices of goods are going to decrease tomorrow (deflation), you will not spend and hold onto your money today (stops economic growth). So, what can the Federal Reserve do to meet their healthy 2% inflation target? They can either print money (quantitative easing) or lower interest rates. By printing money, the Fed increases the supply of money, which causes inflation to rise. By lowering interest rates, the Fed incentivizes borrowing and investing, which leads to more economic growth, which causes inflation to rise.
Now, you might be thinking that the Fed printed and injected trillions of dollars into the US Economy after the great recession. Why didn’t that cause inflation to rise? Well, the truth is that, in theory, Quantitative Easing (QE) should have led to high inflation. However, in reality, it barely caused any inflation. I believe that this is possibly because all the money that was injected into US economy could have flowed into the stock market or the bond market, instead of flowing into the pockets of average Joe (by wage growth). After all, how could the prices of goods go up if the paycheck that average Joe received to buy those goods did not go up?
In conclusion, the US Economy is doing well. There are some potential risks abroad – slowdown in China and Europe. There are uncertainties associated with trade policies and Brexit. The US inflation is below the targeted 2% level. In order to compensate for the low inflation and nurture economic growth amid slowing global growth, the Federal Reserve decided to decrease the interest rates by 0.25%. In other words, the Fed added some more punch in the punch bowl so that the party can go on for a little longer.
Hope you learned a little and found this blog post helpful. We talked about the US Economy, the Federal Reserve, and the Interest Rates. We saw that even thought the US Economy is performing well, the Fed had to cut rates due to low inflation and global slowdown. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations, and general investment ideas are not to be actioned with real money. Vyom Joshi is not a professional money manager or a financial advisor. Contact a professional and certified financial advisor before making any financial decisions.