Much has been written about the need for the Federal Reserve to lower interest rates, even beyond the July cut, the first one in eleven years.  Indeed, the latest escalation of trade tensions with China and its concomitant currency depreciation might make further cuts more compelling. Or not.  The principal purpose of a rate cut is to provide liquidity to foster greater consumption and business investment that stimulate economic growth in the face of sustained opposition forces.  But rate cuts without sufficient justification, such as those based on transitory developments, reaction to presidential jawboning, miming other central banks, or inadequate consideration of market fundamentals can thwart economic progress.

The Case for Rate Reduction

The sentiment for Fed rate reduction is predicated primarily on suppressed demand resulting from slow global economic growth and uncertainty about U.S.-China trade policy, exacerbated by sudden contagion concerns over China’s recent currency weakening.  Technical factors, such as an inverted yield curve, negative interest rates in Europe and Japan, and a seeming tendency to coordinate rate policy with other central banks, also underpin support for lower rates in the U.S.  In fact, current interest-rate futures markets suggest the likelihood of two more rate cuts this year. 

The latest Fed guidance that prompted last month’s rate cut expresses an interest in pre-empting recession rather than reacting to it.  Also factoring into monetary dovishness is the Fed’s aversion to roiling the stock market that is very sensitive to interest-rate movements.  And one wonders if the Fed fears Trump’s wrath over what he thinks are excessively high rates that suppress growth, especially as the 2020 election approaches.  The danger of the Fed’s lack of independence may be illustrated by Fed chairman Arthur Burns’ alleged complicity in opening the monetary spigot to accommodate President Nixon’s reelection in 1972.  That liquidity, coupled with the spending for the Vietnam War, triggered hyperinflation for the rest of the decade.

The Case Against Rate Reduction

Many economic flags favoring the call for rate reduction have been short-lived.  For example, the major stock market correction following last December’s rate hike gave way in short order to record levels again.  Current concern about manipulation of the yuan quickly abated after China downplayed the change as only a technical adjustment to blunt the effect of slower growth, and to offset the effect of U.S. tariffs.  That explanation precipitated another sharp rebound in stock prices.  Moreover, rate-cut advocates possibly exaggerate the impact of a trade war inasmuch as production subject to tariffs constitute a very small percentage of the $88 trillion global GDP, and tariffs will likely only partially translate to higher prices.  Indeed, supply chains have shown to be flexible in remapping the flow of goods as to mitigate trade obstacles.  Meanwhile, salutary growth, inflation and employment, if sustained, argue against rate cuts.

Nonetheless, the equity markets have fluctuated significantly in direct relation to the prospect of a trade agreement with China.  But the U.S. must stand firm and use its superior economic leverage to exact truly fair terms that will save hundreds of billions of dollars annually, notwithstanding some pain.  Then the stock market will flourish sustainably.

A Currency War with China is Not in the Cards

To be sure, China is loath to revisit the problems that ensued from its currency devaluation in 2015.  Consequences included significant capital flight, appreciation of what today is nearly $1 trillion of dollar-denominated debt, and beggar-thy-neighbor devaluations in Asia.  To recover, Beijing expended huge foreign-exchange reserves to prop up the yuan.  It also imposed stricter currency controls with highly punitive consequences for violators.  Today, China zealously seeks to establish the yuan as an internationally traded currency.  That requires demonstrated exchange-rate stability.  As such, China is not likely to adopt a mercantilist devaluation policy.

At the same time, the U.S. Treasury is not likely to engage in a currency war with China, despite President Trump’s preference for weakening an overvalued dollar to keep exports competitive.  The dollar’s safe-haven status, bolstered by a healthy U.S. economy amid global economic weakness, precludes significant depreciation.  Besides, the Fed’s sale of its minimal reserve dollars into the vast foreign-exchange markets to lower the value of the dollar would be fruitless.

The Inverted Yield Curve

Of note, the inverted yield curve, where short-term government bond rates exceed long-term rates, historically augurs recession.  But some of that anomaly may be attributed to suppressed long-term rates resulting from inordinate global safe-haven investing in U.S. Treasurys.  This caution is a response to economic uncertainty associated with the aforementioned global growth slowdown, trade tensions, and currency competition, as well as to geopolitical factors involving Iran, North Korea, Syria, Hong Kong, Venezuela, and Brexit. 

Adverse Consequences of Excessively Low Rates

Low rates penalize savers and squeeze bank profitability, thus restricting the ability to lend. What’s more, they encourage excessive borrowing at a time when governments, businesses, and individuals are overleveraged, creating a drag on growth.  Furthermore, an unnecessary rate cut from today’s relatively low levels squanders a limited opportunity to employ it later when needed to ward off disinflation or recession, unless the Fed entertains negative rates.  But it is noteworthy that longtime negative interest rates in Europe and Japan have failed to stimulate growth appreciably.

A Return to Normalcy

The U.S. economic recovery is ten years old and ripe for reversal by historical standards.  In addition, slow growth in Europe and China intensifies and may spill over to the U.S., as near-record government bond yields possibly portend.  If economic fundamentals deteriorate such that oncoming recession is evident, the Fed cannot raise interest rates until the next recovery.

But in the absence of recession, it is time to resume normalizing interest rates after more than a decade of post-crisis curatives.  The Fed should not lose sight of the “natural” interest-rate needed to return capital from inflated financial markets to the real economy.  Higher rates are also necessary to reward savers who rely on the liquidity, safety, and income of bank accounts and CDs.  On the contrary, rate cuts encourage investors to seek higher returns from risky financial assets. 

In the return to normalcy, the Fed has to restart quantitative tightening to pare its $3.6 trillion remaining bond portfolio.  The original purpose of Fed bond purchases was to lower long-term rates to accommodate chiefly the damaged housing market in the aftermath of the 2008 financial crisis.  But today that market is not as sensitive to long-term rate reduction as it was then.  In any case, the Fed cannot appreciably control the myriad forces that determine long-term rates.  The Fed must end its undue influence on capital flows originally predicated on correcting crisis conditions that no longer apply.

U.S. economic growth continues apace amid record low unemployment and chronically soft inflation, which may constitute a structural change brought about by technological advances and more efficient supply chains that contain production costs.  These conditions do not support rate cuts.  In addition, business investment and home buying demand may be satisfied after so many years of low rates as not to respond to further rate cuts.  University of Chicago economist Austan Goolsby discusses this phenomenon in his 8/4/19 New York Times article, “Why Rate Cuts Don’t Help Much Anymore.”

Despite some adverse effects, retaliatory tariffs affecting U.S. exports and imports should be a temporary price to rectify historically unfair trade agreements and to protect related national security.  This cost does not outweigh the benefit of raising rates when conditions permit.  Today’s rock-bottom interest rates in the bond markets reflect overstated fears about trade and currency battles, as well as ongoing economic sclerosis from stifling taxes and regulation outside the U.S.  While that malaise does weigh on the U.S. economy to some degree, the country is independently prosperous enough for the Fed to separate itself from the rate-cut fever engulfing other central banks in their desperation to stimulate their moribund economies.

William J. Dodwell is a retired corporate executive, management consultant and writer in the financial industry with particular expertise in the capital markets.  He has written in professional journals, the trade press and corporate publications. Mr. Dodwell is a Certified Public Accountant (Retired) licensed in the State of New York.  He has a website called The Comprehensive Conservative in which he writes primarily long form pieces on politics, culture and the economy.  It may be accessed at http://www.williamjdodwell.com/