Despite a solid economy, Fed cuts its key rate by quarter point to ward off a recession

WASHINGTON– The Federal Reserve gave the U.S. economy a rare immunization shot Wednesday as it sought to extend a record 10-year-old expansion that faces mounting risks.

Despite a generally healthy economy, the Fed cut its key short-term interest rate for the first time in more than a decade in a bid to head off a possible recession spurred by global troubles and trade tensions.

As expected, the Fed lowered its federal funds rate by a quarter-percentage point to a range of 2% to 2.25%. The move is expected to ripple through the economy and financial system, nudging down rates for credit cards, home equity lines and auto loans and theoretically sparking more economic activity. While the rate cut should aid borrowers, it will frustrate savers who were just starting to benefit from higher bank account yields.

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Yet it reverses just a fraction of the nine rate hikes the Fed enacted from late 2015 to late 2018 to prevent an eventual inflation run-up and bring borrowing costs back to normal – years after the Great Recession of 2007-2009.

“In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the (Fed’s policymaking committee) decided to lower” its key rate to a range of 2% to 2,25%,” the Fed said in a statement after a two-day meeting.

Fed Chairman Jerome Powell told reporters he didn’t see Wednesday’s move as the start of a lengthy rate cut cycle. “That’s not what we’re seeing now,” he said. 

But he didn’t rule out further decreases, saying it would depend on global growth, Trade tensions and low inflation. 

“We see (these risks) as threats to the favorable outlook,” he said. 

Wall Street reacted with disappointment. The Dow Jones industrial average fell more than 300 points, or 1%, to 26,895 as of 3:13 p.m. on Wednesday. The yield on the 10-year Treasury dropped to 2.02%.

The central bank also agreed to end a campaign to shrink its $3.8 trillion balance sheet two months earlier than anticipated in a move that should hold down long-term rates.

More cuts may be on the way. Before the Fed action, Fed fund futures markets priced in up to three rate decreases this year and four within 12 months. But the Fed may be taking a wait-and-see approach. As it weighs future rate decisions, it said “it will continue to monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.”

In its June statement, the Fed said it will “closely monitor” developments. Keeping that language would have more clearly foreshadowed one or more rate cuts in the months ahead, Morgan Stanley said in a research note before the meeting.

Despite a 3.7% unemployment rate and economic growth averaging a solid 2.6% the first half of the year, inflation has remained stubbornly below the Fed’s annual 2% target. Meanwhile, sluggish growth in Europe and China has hobbled U.S. exports, and President Trump’s trade war with China has damped business confidence and investment.

The upshot is a split-screen economy, with strong job gains and consumer spending, but lackluster manufacturing output and business outlays threatening to undermine growth. Household consumption makes up about 70% of economic activity.

As a result, the Fed’s action Wednesday is viewed as an unusual “insurance cut,” enacted even though the economy remains sturdy in an effort to stave off a potential downturn. The thinking is that the Fed’s key rate is still historically low and so there’s little room to trim rates to spur growth in case of recession. 

But economists pointedly disagree about what the Fed should be doing. Some, like those at Morgan Stanley, predicted the Fed would lower its rate by half a percentage point Wednesday to provide enough insurance against an economic slide. By cutting a quarter point, the Fed would be “wasting a scarce and valuable…bullet” in its arsenal, the research firm wrote to clients.

Earlier this week, Trump criticized the Fed’s expected quarter point move, tweeting that it “will do very little” compared to anticipated rate cuts by policymakers in Europe and China. Trump has been blasting Fed rate hikes or exhorting it to lower rates the past year, breaking with a long tradition of presidents steering clear of such comments to preserve the agency’s independence.

Yet RBC Capital Markets, citing a lack of “economic distress,” decried any rate cut. “You are giving away your ammunition today,” the firm wrote. That armament could be needed if the economy heads south by next year, as many economists predict.

Kansas City Fed President Esther George and Boston Fed chief Eric Rosengren dissented, preferring to keep rates unchanged.

What the Fed said about:

The economy

The Fed said “economic activity has been rising at a moderate rate.” While “household spending has picked up from earlier in the year, growth of business fixed investment has been soft.”

The economy grew at a respectable 2.1% annual rate in the second quarter following strong gains of 3.1% early in the year and 2.9% in 2018. Strong consumer spending has offset weak business investment manufacturing.

Growth is expected to slow to 2% the second half of the year, well below the 3% or better pace that President Trump has promised. Sixty percent of economists surveyed by the National Association of Business Economics are forecasting a recession in 2020.

Jobs

“Job gains have been solid, on average, in recent months, and the unemployment rate has remain low,” the Fed said.

The economy added a robust 224,000 jobs in June, though monthly job growth has averaged 172,000 this year, down from 223,000 in 2018. That’s still a solid pace in light of federal tax cuts and spending increases that juiced the economy last year but are now fading and a jobless rate that’s close to a 50-year low and making it harder to find qualified workers.

The balance sheet

Since October 2017, the Fed was gradually shedding the $3.5 trillion in Treasury bonds and mortgage-backed securities it purchased after the financial crisis to lower long-term rates and spur growth. As a result, the Fed’s total asset portfolio has fallen to $3.8 trillion from a peak of $4.5 trillion.

Rather than sell the bonds, the Fed has scaled back reinvestment of their proceeds as they mature, putting upward pressure on long-term rates. Earlier this year, the central bank said it would stop that initiative in September, earlier than anticipated, by reducing the amount that comes off its books each month.  

On Wednesday, policymakers said they would halt the balance sheet runoff immediately, keeping $62 billion in its portfolio that it would have shed, according to Morgan Stanley estimates.

The reason: Earlier this year, the Fed released new guidance saying the balance sheet program should not “work at cross purposes” with its key rate, which is now heading lower.

Inflation

The Fed said inflation remains below its 2% target and noted that bond prices reflect inflation expectations remain low.

The Fed’s preferred yearly inflation measure was at 1.4% in June and a reading that strips out volatile food and energy items was at 1.6%, both well below the Fed’s 2% benchmark.

What it means

The Fed took a middle-ground approach. It reduced rates by a quarter point, despite a solid economy, to mitigate recession risks. But the cut was less than the half point some economists advocated. Further cuts could be coming depending on trade and global economic developments.

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