Equity investors are euphoric about the Federal Reserve’s expected move to lower interest rates, after its four small increases in 2018. However, rates are still far below normal levels, so this move would create serious problems for government policy and investor choice.
By keeping interest rates so low for so long, the Federal Reserve is losing its best monetary tool for fighting the next recession, and implicitly undermining Congressional efforts to constrain spending and preserve fiscal firepower. During this extended period, the Fed’s suppression of interest rates is also taking a heavy toll on bond investors: They can’t find relatively safe bonds with reasonable yields, so they are reaching for higher yields by buying very risky bonds.
When the U.S. economy falls into the next recession, as it inevitably must, the Federal Reserve needs to respond by sharply lowering interest rates. This is the main monetary tool the Fed has to push the economy back into a growth mode. However, U.S. interest rates are now so low that the Fed has little dry powder in its arsenal. For example, rates on 10-year U.S. Treasury bonds have dropped to 2%, as compared to a 5% average before the last financial crisis in 2008.
While business executives are now worried about a possible trade war and have slowed their expansionary plans, the U.S. economy is still healthy. Unemployment is below 4%, inflation is below 2%, and consumer spending is strong. If the Federal Reserve is going to cut interest rates every time the economy becomes a little soft, what firepower will it have left for a real recession?
Moreover, the Federal Reserve’s willingness to cut interest rates implicitly discourages Congress from keeping federal budgets under control. If the Fed will come to the rescue of any economic weakness with monetary stimulus, why go through the difficult political process of reining in spending on domestic and military programs? The White House and Congress are close to agreeing on a federal budget for the next two years, which would increase spending and result in large annual deficits. By 2029, projected federal spending will bring the national debt to around 93% of our gross domestic product.
Read the full post at Fortune.
Robert C. Pozen is currently a Senior Lecturer at MIT Sloan School of Management and a Senior Fellow at the Brookings Institution.