{ "id": "IN11152", "type": "CRS Insight", "typeId": "INSIGHTS", "number": "IN11152", "active": true, "source": "EveryCRSReport.com", "versions": [ { "source": "EveryCRSReport.com", "id": 603183, "date": "2019-08-01", "retrieved": "2019-08-12T22:10:51.779113", "title": "Why Is the Federal Reserve Reducing Interest Rates?", "summary": "On July 31, the Federal Reserve (Fed) reduced the federal funds rate by a quarter of a percentage point. The Fed targets this rate to meet its statutory mandate of maximum employment and stable prices (defined as 2% inflation). Lower interest rates would tend to raise employment and inflation, all else equal. \nFed Rate Cuts Across the Business Cycle\nThe Fed typically cuts rates during recessions and raises rates during expansions. Since the Fed began using the federal funds rate as its primary instrument to carry out monetary policy (possibly as early as 1982), it has had four periods of sustained rate reductions (see Figure 1). Three out of four of those episodes coincided with the last three recessions. (The fourth was after the 1981-1982 recession, when the Fed had raised rates to their highest level on record, causing inflation to drop rapidly.) Notably, in all three of those cases, the Fed began to reduce rates 2 months to 12 months before the recession began and continued to reduce or maintain low rates into the beginning of the recovery.\nRates were also briefly cut three other times during these expansions. The 1987-1988 rate reductions were in response to a large drop in the stock market. The Fed justified the 1995-1996 reductions by stating that \u201cas a result of the monetary tightening initiated in early 1994, inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions.\u201d The Fed cut rates in 1998 in response to financial turmoil related to the Russian debt crisis and the failure of a large hedge fund. In hindsight, financial turmoil in 1987 and 1998 did not have a long-lasting effect on financial conditions or the broader economy, but there was considerable fear at the time that they would. The Fed resumed rate increases within about a year of all of these reductions.\nThe recent rate cut is starting from a lower federal funds rate than any previous cut since 1982. This is in part because the neutral rate that neither stimulates nor restrains economic activity is thought to have fallen. It is also because the Fed never employed contractionary monetary policy in this expansion, unlike at the peak of previous expansions.\nFigure 1. Federal Funds Rate Target\n1982-2019\n/\nSource: St. Louis Fed, FRED.\nNotes: The Fed switched from a point target to a target range in 2008.\nThe Current Context\nIs the Fed cutting rates to fend off an impending recession? Or is it a temporary blip similar to 1987, 1996, and 1998? Current available data may help answer those questions, with the caveat that the Fed has more up-to-date confidential data that may paint a different picture. \nWhat many find striking about the Fed\u2019s decision to cut rates is that the unemployment rate has been at its lowest rate this year since 1969, below the Fed\u2019s estimate of the longer-run unemployment rate consistent with maximum employment. Indeed, the unemployment rate is lower today (3.7%) than when the Fed last raised rates in December 2018 (3.9%).\nEconomic growth slowed from 3.1% in the first quarter of 2019 to 2.1% in the second quarter (see Figure 2). However, at full employment, the economy cannot persistently grow faster than its long-run trend, and the second quarter growth rate is slightly higher than the Fed\u2019s projection of longer-run growth and slightly lower than this expansion\u2019s average.\nFigure 2. Quarterly Economic Growth Rates\n2009:3-2019:2\n/\nSource: Bureau of Economic Analysis.\nNotes: Growth rates are annualized.\nEmployment growth also shows no sign of a recession, and only a modest cooling off from 2018 (see Figure 3). Although job growth was relatively weak in May (72,000 jobs added), it was relatively strong in June (224,000) and for 2019 to date (a monthly average of 172,000, compared to 223,000 in 2018). Because jobs data are highly volatile, too much cannot be inferred from a one-month change.\nFigure 3. Monthly Change in Employment\n2010-2019\n/\nSource: Bureau of Labor Statistics.\nEconomic theory predicts that low unemployment would push inflation higher, but this has not occurred recently. The Fed might be reducing rates because inflation has fallen below its 2% target, although the timing would be a little off\u2014inflation first fell below 2% in October 2018 (or July 2018 if food and energy prices are excluded), and it has ticked back up again slightly since March (see Figure 4). However, the Fed might have wanted to ensure that inflation would remain persistently below 2% before cutting rates.\nFigure 4. Inflation Rate\n2009-2019\n/\nSource: Bureau of Economic Analysis.\nNotes: 12 month change in Personal Consumption Expenditures Index.\nA key principle of monetary policy is that it should be forward looking because of lags between policy changes and their effect on the economy. When deciding to cut rates, the Fed should not consider only current economic performance, but also projections of future performance. As noted above, the Fed typically cuts rates before a recession has begun, and there are some recession warning signals, such as the yield curve inversion, which, if accurate, would justify lower rates. The Fed does not project a recession this year or next, however, so that would not seem to motivate its rate decision.\nDespite its view that a sustained expansion and strong labor markets are the most likely outcomes, the Fed cited global developments and muted inflationary pressures as justification for cutting rates. There are always risks to the outlook, however, especially from abroad. Unlike the 1987 and 1998 episodes, there has been no major disruption in financial markets. (There were large declines in the stock market last December and May, but both subsequently completely reversed.) Some have described this cut as \u201cinsurance\u201d in case conditions worsen, but cutting rates also poses a risk of overheating that could threaten the expansion.\nFed Independence\nGiven the lack of official evidence that the economy has weakened, some question whether President Trump\u2019s repeated calls for the Fed to reduce rates has been effective. If so, this would raise questions about whether the Fed\u2019s independence has been compromised, which could have implications for the Fed\u2019s credibility going forward. When asked whether the President\u2019s requests have influenced Fed policy, Fed Chairman Jerome Powell recently testified \u201cNot at all.\u201d", "type": "CRS Insight", "typeId": "INSIGHTS", "active": true, "formats": [ { "format": "HTML", "encoding": "utf-8", "url": "https://www.crs.gov/Reports/IN11152", "sha1": "aa3862134d1e532eb5cf0157573e9b318dbeb23f", "filename": "files/20190801_IN11152_aa3862134d1e532eb5cf0157573e9b318dbeb23f.html", "images": { "/products/Getimages/?directory=IN/ASPX/IN11152_files&id=/3.png": "files/20190801_IN11152_images_2e00ebf97a183d76a7b59ea763fb726f5a339772.png", "/products/Getimages/?directory=IN/ASPX/IN11152_files&id=/2.png": "files/20190801_IN11152_images_a3ff09808a89058def03a64acf3fdd37c4cf5040.png", "/products/Getimages/?directory=IN/ASPX/IN11152_files&id=/1.png": "files/20190801_IN11152_images_70a0afe6580e59789b155d0b3714f24f490bd7e6.png", "/products/Getimages/?directory=IN/ASPX/IN11152_files&id=/0.png": "files/20190801_IN11152_images_3a4e0a7542b20ac5d9d5468979a076a39651e755.png" } } ], "topics": [] } ], "topics": [ "CRS Insights" ] }