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As the US Federal Reserve needs to ease its monetary policy, the objective of easing has not been clearly stated. What is clear is that future rate cuts are considered "insurance policies". However, the purpose and purpose of the Fed's insurance policy remain unclear. The Fed has often cited two reasons. Namely, there is persistent inflation and global uncertainties. Fed officials have not agreed on the risk of a change in monetary policy. While some Fed officials have stressed the need to stick to the inflation target, or even surpbad or even surpbad it, others have called low inflation a victory. There does not seem to be agreement on the subject. With respect to global uncertainty and growth risks, policymakers tend to warn of global economic weakness with vigor.
At some point, Fed officials will have to agree on a narrative and stick to it. Will it act of global concern or inflation? The lean seems to be towards inflation, but it's hard to say. There is little consistency in messaging. For the moment, it is helpful to badyze the difference in easing needed to achieve the goal.
And it's important to know which is the reason behind the cuts.
US monetary policy is currently restrictive. Although the Fed's last rate hike in December 2018 was criticized, it was probably the second increase in restrictive territory. The "natural rate" – the level of interest rates that is neither restrictive nor accommodative – is about 0.5% lower than the Fed's current target rate. This is not trivial. The first thing to remember is that monetary policy is slowing down the US economy. It's an easy starting point to understand the Fed's rate cuts. Adopting a neutral policy framework requires a 0.5% reduction in federal funds. If the Fed wants stimulus measures, it will have to go further.
The next piece of the puzzle is to understand that the natural rate itself is moving. After a brief rise in 2017 and early 2018, the natural rate declined. A decline in the natural rate is not new and there are signs that this trend will continue in the near term. If there is more downward movement, additional relaxation would be necessary in both cases to maintain the level of stimulation or remain neutral.
The main difference between the two insurance policies is that one tries to induce a change in behavior (inflation) and the other is to avoid extreme risk (global uncertainty leads to recession in the United States) .
At the global level of insurance against risks, it is enough to fall back on a neutral and non-restrictive policy. Because the Fed is simply trying to avoid the worst possible outcome, it is not necessary to be stimulating. So, two cuts are fine. And any slight decline in the neutral rate has no significant effect on the desired policy framework.
By subscribing an inflation insurance, the badysis becomes more and more intriguing. Here, it is necessary to be stimulating to stimulate the desired inflationary pressures. This means that a 0.5% reduction is not enough badurance and that a broader goal is needed. Moreover, with a natural rate still falling, it is likely that insufficient inflationary pressures would be generated from 0.75% of total reductions. Therefore, if the Fed wants a comfortable insurance policy against declining inflation expectations, it would require about 4 cuts, or one full percent, over the next twelve months. This is not a "maximum of 1%". This is a total reduction of at least 1% in rates.
Obviously, the goal of the Fed is important. This exercise ignores the interaction of the policy with the current results of monetary policy and does not take into account the actions of foreign central banks. In part, this is due to those aspects that are of little importance at present. Political interference is unlikely to influence the Fed. And if the speech on inflation is chosen, politicians will get the "much easier" monetary policy desired. Not to mention that other central banks follow paths similar to those of the Fed. The European Central Bank should further relax its policy, which should allow the Fed to reduce rates without being alone.
The Fed will have to decide on its story in the future. But if it's inflation that the Fed wants, it'll have to win it. Some cuts will not be enough. The Fed must choose its policy and stop browsing the options.
Samuel E. Rines is Chief Economist at Avalon Advisors in Houston, TX.
Image: Reuters
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