If Our Economy Is So Great, Why Did The Fed Vote To Juice It?
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Last week, policymakers at the Federal Reserve voted to bring interest rates down. Down! That's despite a decade of economic growth, record low unemployment, solid corporate profits and a good stock market. And it's despite the fact the federal government has already been juicing the economy with big spending and tax cuts. In the old days, the Fed would be worried this would all make the price of everything explode (inflation), and it would be voting to increase rates to slow things down. But, no. The governors are putting their foot on the accelerator. Fed Chairman Jerome Powell, at a news conference, explained that "weak global growth, trade policy uncertainty, and muted inflation have prompted [us] to adjust [our] assessment of the appropriate path of interest rates."
The Fed's decision has gotten a lot of attention (including this Indicator throwdown episode). But, we've been wondering, maybe the correct reaction should just be the shrug emoji ¯\_(ツ)_/¯.
Fed up with myths
Former Fed Chairman Ben Bernanke, shortly after leaving the helm of the Fed, wrote that he was pretty exasperated by the general public's failure to grasp just how limited the Fed's power is. Bernanke wrote: "If you asked the person in the street, 'Why are interest rates so low?', he or she would likely answer that the Fed is keeping them low. That's true only in a very narrow sense."
Translation: "We're not superheroes here, you know. We don't have the power over the economy that you think we do."
The main way the Fed influences interest rates is very narrow, usually through a policy lever known as the federal funds rate. It's the rate banks charge each other to borrow money overnight. By making it cheaper for banks to borrow, it makes it cheaper for businesses and households to borrow. That is the traditional way the Fed has tried to boost the economy. It injects more money into the system.
The federal funds rate is an important interest rate, and it influences other interest rates — on mortgages, business loans, credit cards, etc. — in the short term, but the Fed's power over interest rates in general is very limited. The market ultimately determines real interest rates, not the Fed.
To understand why interest rates are so low, it's helpful to think like central bankers. When they make their decisions, they have a theoretical interest rate in mind. In typical central banker fashion, it has a bunch of confusing names that make your eyes glaze over: the equilibrium real interest rate, the Wicksellian interest rate, r-star, or the natural rate of interest. Central bankers like Powell have been increasingly calling it the "neutral rate," so we'll go with that.
The neutral rate is a theoretical resting place for interest rates. And the Fed doesn't control it. Putting a number on it is a guess, or a moving target. It's basically the interest rate in the economy's sweet spot. It's where the cost of borrowing money makes everything hum nicely. Basically everyone is employed if they want to be. All factories and machinery and technology are put to use. And the price of everything is pretty stable (not a lot of inflation). Not too hot. Not too cold. It's the natural or neutral place to be.
This theoretical rate, like the real-world interest rates it represents, is ultimately set by the markets for money coming together. On one side, is all our savings. Our bank accounts, pension funds and so on. That's the supply of money for the stuff (capital) that grows our economy. On the other side, is that stuff, aka investment: factories, houses, laboratories, rocket ships, office chairs. That's the demand for money. It's a gazillion buyers and sellers all coming together to agree on the price of borrowing money.
The issue the Fed — and all of us, really — have been facing is that the neutral rate has been falling and falling and falling, since even before the financial crisis. That's why the Fed is finding itself having to lower the interest rates under its influence now — even this far into an economic expansion. The fact that the neutral rate is so low is a reflection of a fundamental economic issue: there's a big supply of savings floating out there, but there's nowhere near the demand for investment. And that lack of investment is bad news for economic growth.
Where is the investment?
The Trump administration sold the Tax Cuts and Jobs Act as a solution to the problem of lackluster investment. In our first Planet Money newsletter, we interviewed Kevin Hassett, who was then one of Trump's chief economic advisers. He argued that cutting the tax rate on corporations would result in an investment boom. But, as the Fed acknowledged in a statement justifying its actions last week, the growth of investment over the past year has been "soft."
Investment is a big deal because it gives us more machines and tools and structures that make workers better at their jobs — it increases productivity — and that is key to better wages, economic growth and, ultimately, an improving standard of living.
It's possible investment doesn't look great because the escalating trade war is scaring businesses away from investing. But this problem of lackluster investment and productivity growth has been with us for decades now — and the Fed has proved that no matter how cheap it makes it to borrow money, investment and productivity remain disappointing. The economy may look good on some levels, but it's still missing key ingredients that would make it look way better.
The Fed can grease the wheels of the economy with cheaper credit, and it can help guide it in a better direction, but it can't fix the engine. So when the Fed cut the federal funds rate by a tiny amount, that's why our reaction was basically ¯\_(ツ)_/¯. It's not going to fundamentally fix intractable problems like low investment and productivity growth.
The fall of the neutral rate is a big deal, especially because with rates so low, the Fed currently might not have enough room to cut when the next recession hits. Why after a decade of economic growth, with deficit spending and corporate tax cuts, and with the Fed keeping its foot on the accelerator, are we not seeing more growth?
Next week in Planet Money's newsletter: we dive into a theory that tries to explain it. You can sign up here.
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