Introduction to Central Banks
Traditionally, central banks have been thought of as staid, conservative institutions, and most people found monetary policy to be a very boring topic. However, this perception is changing, and central banks are now at the center of attention. The recent drama surrounding the Federal Reserve, with its rate cuts and personnel changes, is a prime example of this shift.
The Federal Reserve’s Recent Moves
Just days before the scheduled meeting of its monetary policy body, the FOMC, it was still unclear who would attend. Governor Lisa Cook was fired by President Trump for allegedly being dishonest on a mortgage application, but she challenged the dismissal, and a court ruled that she must remain in her role for now. Meanwhile, the senate confirmation process was rushed to get Stephen Miran, a Trump adviser, on the board just in time for him to vote. Trump has been pushing aggressively for the Fed to lower borrowing costs. In the end, the drama was unnecessary, as Cook joined the rest of the committee in voting for a 25-basis points rate cut. Miran voted for a 50-basis points reduction.
Implications of the Rate Cut
The 25-basis point reduction in the fed funds rate was expected and means the Fed joins many other central banks in resuming its cutting cycle. The bigger question is how far and how deep this cycle goes. It will have implications for investors all over the world, since the Fed is still the most important central bank. Central banks can lower interest rates for good or bad reasons. A “good” cut would be when inflation is falling or is expected to fall, and high interest rates are no longer needed. This is sometimes characterized as a soft landing, since the economy did not buckle under the weight of high interest rates but can now benefit from lower borrowing costs.
Interpreting the Rate Cut
If we take recent US interest rate cycles as an example, the 2019 pivot was a “good” cut, while the plunge in rates in 2020 was “bad” since it was a response to the Covid economic shutdown. The 2024 reductions fall into the good camp again, since inflation had come way down while the economy remained resilient – a soft landing. Last week’s rate cut falls in between, making it less straightforward to interpret. Even Chair Powell acknowledged this in the press conference, noting that it’s “challenging to know what to do”. Part of the problem is that the Fed, unlike most other central banks, has a dual mandate: stable prices and maximum employment. The twin objectives are pulling in different directions.
The Current Economic Situation
Inflation has been rising recently, moving away from the 2% target. Some of this is due to import tariffs and is likely to be once off. However, there are signs of sticky inflation in areas where tariffs should have no direct impact, such as non-housing services. The last thing the Fed wants to see is unaffected companies raising prices and blaming it on tariffs. On the other hand, economic growth has moderated, and job creation is stalling. This too is partly tariff-related, with the massive uncertainty around trade policies probably resulting in firms postponing hiring decisions. Companies could also be experimenting with artificial intelligence to see if they can get away without adding staff.
Conclusion
In conclusion, the recent rate cut by the Federal Reserve is a complex issue with both positive and negative implications. While it may provide a boost to the economy, it also raises concerns about inflation and the potential for a recession. As the Fed navigates its dual mandate, it must carefully consider the impact of its decisions on the economy and investors. The coming months will be crucial in determining the direction of the economy, and investors must stay informed and adapt to the changing landscape. The fate of the Fed’s leadership, including Chair Powell’s term expiration, will also play a significant role in shaping the future of monetary policy.
