In one sense, you could say that the Fed’s decision on Wednesday to cut interest rates was of minimal importance. The interest rate that the Fed controls more or less directly — the federal funds rate — is the rate at which banks lend money to each other overnight. And it’s hard to imagine businesses or consumers changing their plans because the annualized overnight lending rate has fallen by half a percentage point, from about 5.5% to about 5% — meaning that if you borrow $1,000, your next-day repayment falls by 1.4 cents. But it was a momentous move nonetheless. For one thing, Fed rate changes tend to feed through to long-term interest rates, which are the ones that really matter to the economy. For example, the Fed’s series of rate hikes in 2022 and 2023 pushed interest rates on 30-year fixed-rate mortgages up to nearly 8% from around 3%. More importantly, by beginning to cut rates, the Fed—which began raising rates in 2022 in an attempt to control rising prices—has effectively declared its belief that the war on inflation is won. Why should we care what the Fed thinks? Let me tell you a secret: Jerome Powell, the chairman of the US central bank, and his colleagues do not have any inside information about the state of the economy. (Okay, they may get advance notice if, say, a big bank is about to fail.) Most of their decisions are based on the same data on unemployment, inflation, etc. that is available to anyone with an internet connection. It’s true that the Fed has some very smart economists on staff. But there are plenty of smart economists outside it, too. The implicit declaration that inflation has been defeated won't be news to anyone who, say, has followed Moody's Mark Zandi or Goldman Sachs' Jan Hatzius, who have been telling us for months that inflation is under control. Yet the Fed's political role lends it a certain solemnity, meaning that its opinion carries special weight with investors and, perhaps more importantly, with the broader public. So it's important for the Fed to declare that inflation is no longer a danger. But this good news raises two questions. First, if inflation is, as Powell said in his press conference, close to the central bank's 2% target, why haven't he and his colleagues cut rates further? The Fed's interest-rate-setting committee, which meets eight times a year, typically moves rates gradually, a quarter-point at a time. The big debate before this meeting was whether it would be a standard quarter-point cut or, what we actually got, a giant half-point cut. But rather than thinking about increments, suppose we ask simply what level of interest rates makes sense right now. Inflation appears to be under control; labor markets appear to be weakening, with the unemployment rate still fairly low but significantly above its low point last year, and hiring slowing. Overall, as Powell said in his press conference, the labor market looks a bit cooler than it was on the eve of the pandemic. However, the overnight rate was at 1.75% at the end of 2019. There are some dubious arguments that we can maintain full employment at a somewhat higher interest rate now; participants at Wednesday’s committee meeting were on average predicting that the interest rate will settle at 2.9%. But I haven’t seen any plausible argument for a “neutral” rate higher than 4% at most. And despite the massive cut, rates remain at 5%. Shouldn’t the Fed act more quickly to normalize rates (and minimize the risk of recession)? Second, will the Fed’s green light persuade more Americans to reevaluate President Biden’s economic record? We experienced a temporary burst of inflation in the wake of the Covid pandemic, but so did nearly every other major economy, while overall we have posted much stronger growth than our peers. And as White House economists have noted, our success in bringing down inflation has defied the expectations of pundits who insisted that disinflation would require a big rise in unemployment. I know some people are not content with returning to low inflation and want us to get back to the pre-pandemic level of consumer prices. But we can’t, and even trying would be a very bad idea. Only one president in the past century has presided over a significant decline in consumer prices; his name was Herbert Hoover. The central bank’s move on Wednesday is, of course, good for Kamala Harris. It will give consumers some direct relief on interest costs, and it will signal that we are past inflation. For Powell to claim, as he did in his press conference, that the economy is in “good shape” has to be good for a candidate who is part of the administration that presides over that economy. And almost too predictably, Donald Trump was quick to suggest that perhaps the central bank was “playing politics.” But while the Fed’s action will surely have political consequences, it was not a political decision. The economic case for a rate cut was overwhelming; the case for a big cut was very strong. Not doing so would have been a political decision. And the Fed was not intimidated into not acting. Paul Krugman is a Nobel laureate in economics. © The New York Times, 2024. Translation by News Clips
