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Don’t Expect the Fed to Do It All

The Editors

(Bloomberg Opinion) -- Financial markets are expecting the Federal Reserve to cut its policy interest rate on Wednesday by at least a quarter point. In the past several weeks, the Fed has signaled this change so strongly that a failure to act would come as a jolt. Although the central bank’s immediate intentions may be clear, however, its reasoning is less so.

In a way, that’s inevitable. The Fed is grappling with unusually great uncertainty about where the economy stands. With interest rates already very low, its options are limited. And it has to contend with an unprecedented lack of economic-policy cooperation from Congress and the White House. Under these conditions, its job is next to impossible.

Nonetheless, the Fed needs to get its story straight.

Until recently, officials emphasized “data dependence”: The central bank would cut interest rates if and when incoming information suggested that the economy was cooling. New figures show that growth in the second quarter slowed to 2.1% — better than expected, but still down from 3.1% in the first quarter. The number reflected weaker exports and investment, and gave the central bank reason to move. The trouble is, the apparent deceleration is plausibly due to the administration’s trade-war machinations — a problem that slightly lower interest rates isn’t going to solve.

In his recent testimony to Congress, Fed Chairman Jerome Powell seemed to presage a more fundamental rethink. Among other things, he said that the traditional relationship between low unemployment and rising inflation has broken down, and that, as a result, there’s a danger the economy is being stifled by an inflation rate that’s persistently too low. The implication is that getting inflation higher is now job No. 1 — a bolder mandate than “wait and see.”

This kind of talk is not without risk. It’s true, as Powell notes, that inflation hasn’t taken off despite years of above-trend growth and falling unemployment. In part, however, that’s a tribute to the credibility of the Fed’s inflation target, which helps to restrain wages and other price pressures when an excess of demand over supply shrinks the economy’s spare capacity. Seen this way, the so-called breakdown of the unemployment-inflation relationship is an achievement, not something to be regretted or overcome.

By the way, inflation isn’t unambiguously undershooting the Fed’s target. The Fed’s preferred gauge is personal consumption expenditures excluding food and energy — and this did fall from a 12-month rise of 2% last December to 1.6% this summer. But the so-called trimmed mean PCE is arguably a better measure of the trend, and it has remained steady at about 2%. At the same time, real wage growth has resumed and is supported by a tight labor market. Asset prices are already elevated; financial conditions aren’t crimping this expansion.

In short, the case for the rate cut investors think they’ve been promised is far from watertight. More important than this week’s interest-rate decision, though, is how the Fed explains itself and where it goes from here.

The message shouldn’t be, “We’ll do whatever it takes to push inflation higher.” At some point that stance might be necessary, but current conditions certainly don’t warrant it. In the meantime, the central bank should avoid giving the impression that its tools are adequate to face the challenges facing the economy. If reckless and incompetent trade policy continues to weigh heavily on investment, and if erratic and irresponsible budgets continue to shrink the fiscal room for maneuver, the Fed can’t come to the rescue with interest-rate tweaks. And it shouldn’t suggest otherwise.

--Editors: Clive Crook, Mark Whitehouse

To contact the senior editor responsible for Bloomberg Opinion’s editorials: David Shipley at davidshipley@bloomberg.net, .

Editorials are written by the Bloomberg Opinion editorial board.

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