How Low Should the Federal Funds Rate Go?

Assumedly the Federal Open Market Committee (FOMC) which is the monetary policy making body of the Federal Reserve System (the Fed) should know where the Federal Funds Rate (FFR), its benchmark interest rate, should be for economic stability reasons, but apparently the President believes strongly that they have continued to get it wrong.

A couple days ago the Fed, no doubt influenced in part by the first estimate release of GDP growth for the third quarter suggesting the economy grew by a modest 1.9%, decided to cut interest rates by 0.25% to a range of 1.5% - 1.75% in a move the Fed Chair, Jerome Powell has dubbed preemptive and mimicking a precedent triple cut then wait and see attitude on monetary policy, going forward.

However this move was criticized by President Trump as not being sufficient, with the President citing other Central Bank policies such as the European Central Bank (ECB), in suggesting that the benchmark rate ought to be much closer to zero to provide even greater stimulus to the economy and forestall any slowdown in the economic expansion that is now in its 11th year.

So where should the benchmark interest rate be?

My response here is not a full fledged analytical one that is based off the kind of data the economists and statisticians at the Fed would be looking at and analyzing in providing the information on which policymakers make their decisions. It is more of an intuitive, back of envelope and somewhat theoretical response, but I think it should be enlightening.

From a theoretical point of view the President's position is not without reason. If he has put in place a number of policies that suggest supply side increases in total production then there is scope to encourage corresponding spending by expanding money supply (through interest rate cuts), and perhaps maximally, by reducing interest rates as low as feasible.

Intuitively, supply side policies by expanding production would put a downward pressure on prices (an outcome which is apparently being borne out in our current economic experience - the economy has continued to expand and inflation has been muted, remaining well below the target 2% based off the PCE price index, which is the Fed's preferred measure for gauging inflation).

So what we need to consider here involves two questions. Is it really the case that we are experiencing growth from supply side policies? Would there really be any downside to lowering interest rates more aggressively (to near zero rates)?

Let's investigate these...

Massive deregulation in key industries, tax reform that included significant tax cuts for individuals and businesses, and policies aimed at encouraging domestic production for exports have been the hallmark of the current administration along with the arguably controversial tariffs designed to limit imports and encourage more domestic production in import competing industries. These are policies that in theory affect the supply side.

Businesses of all stripes have therefore been incentivized through reducing their other costs of production to expand production and not necessarily raise prices on their products. The trade war with China though has taken its toll through indirectly raising costs for some businesses who would have otherwise obtained some of these inputs like steel and aluminum at cheaper prices from abroad in the absence of the tariffs but perhaps this has been cushioned by the cost reductions identified previously.

So a credible argument can be made that these policies on the net have spurred output growth and this needs to be matched with a necessary expansion in planned spending to keep businesses optimistic about continuing to expand production.

This brings up the second issue, how much planned spending is needed and is the current level not sufficient such that more stimulus is needed from lowering interest rates even further? This is a tricky question because there might be science and art components involved in providing the "correct" answer.

The science part is what we have to assume the Fed does when weighing the decision on what to do with interest rates, and it has chosen to provide stimulus through a modest rate cut. This decision probably guided by simulations of macro-economic models of the economy designed to include relevant variables and based off scenarios involving varied shocks that could plausibly occur. It's tough to argue against the science as this is the gold standard for economic analysis.

However, the values assigned to variables in the simulations are still choices that the analysts make, and in this instance there may be two outcomes the Fed may want to avoid, which may bias these choices: Having the interest rates fall too low such that inflation suddenly accelerates, given a plausible short run relationship between these two variables; and having the interest rate too low such that if the economy was to slow down from some unanticipated large shock, that there might be no room to use this instrument any further in providing a counter stimulus.

How important are these concerns?

Let's bring in the art component. If inflation is currently running well below the Fed's target rate, and has remained in this range over the past few months, and with the headwinds of economic recessions blowing from across the Atlantic and the Pacific (China's economy has cooled down to growth of about 6%, Brexit is still in limbo, the Euro area is slowing considerably, and there is no clear resolution to the trade war between the US and China) it seems a more aggressive interest rate cut would do no harm but only good by providing the economy with more money to spend on the output that businesses have already stocked up on, encouraging them to ramp up even more production.

Will inflation not accelerate given that we might be operating at above full employment?

This inflationary concern has not yet materialized despite years of many suggesting it would, especially given the Fed's huge monetary stimulus from Quantitative Easing and years of keeping the interest rates near zero. I think it is time that we consider seriously the possibility that we are experiencing supply side driven output growth, which is the reason for why we have not yet seen considerable inflation.

Further, I think even if inflation was to rise to 2.5% that it would not be the death of us, especially if it is being driven by faster output growth. One of the lessons to be learned from monetarism is that recessions tend to be preceded by insufficient money supply. We may do wisely to err on the part of providing too much rather than too little money to support an economy in an expansion.

The science component may look at the growth rate of output and suggest that the Fed policy will ensure that money supply is currently growing at a rate that keeps prices stable, but this may be incorrect since that growth rate of output may be influenced by the fact that there just isn't enough money supply growth to support a faster growth rate. So the art component here would involve taking a risk on inflation by expanding money supply even further and watching to see if this provides support for faster economic growth given the assumption that there is scope for this from the supply side policies already at work.

In light of today's October jobs report, this is all the more justified. The unemployment rate ticked up slightly to 3.6% and the number of jobs added, though positive, is now in the third successive month in decline, and for this year on average, slower than in prior years. The economy while robust appears to be showing initial signs of slowing, and as this has already been visible in manufacturing more stimulus might have been welcome.

How about the concern that close to zero rates will limit the Fed's ability to react to an unanticipated large shock?

I think it is somewhat clear that the Fed has matured since the Great Recession and policymakers know that they have other tools they can use that may provide additional stimulus when the benchmark rate has hit the zero lower bound. It may even be the case that perhaps by lowering rates even further, we are much better able to cope with such an unanticipated large shock should that occur, but better still, this move may actually put the economy on a path where such a shock does not materialize in the first place.

The President may be right on this one, and while the economist in me should feel ashamed that I am actually going against a team of leading experts in the field who would know better, I am slightly encouraged by the fact that while the President does send out the tweets, there has to be some economic advisors prodding him on, who perhaps are seeing things somewhat similar to what I have explained above.