Are Rate Cuts The Answer?

There are signs of an economic slowdown, but lowering interest rates may not work this time.
August 6, 2019 Updated: August 7, 2019

The Federal Reserve has cut interest rates for the first time since the depths of the Great Recession 2008, leaving many to wonder just what the Fed knows that it’s not disclosing.

The short-term interest rate was cut by only .25 percent, half of what the Trump administration wanted and says that the economy needs. At least one other quarter-point cut is now expected before the end of the year. But it’s not clear that interest rate cuts will remedy what’s ailing the economy. What is apparent, however, is that the rise in interest rates that many expected over the past year isn’t likely to happen anytime soon.

The logic of lower interest rates is pretty straightforward. Rate cuts typically stimulate the economy by lowering the cost of borrowing. Businesses are expected to take advantage of those lower costs by expanding production, which often includes hiring more workers. And consumers are expected to react by buying and borrowing more. Credit cards and home mortgages, for example, become relatively cheaper and they are key parts of the consumer economy.

Of course, rate cuts also tend to give the stock market boost, at least in the very short term.  But the stock market is not to be confused with the economy.

But is this interest rate cut good news for the economy right now?

A Mixed Economic Outlook

Not necessarily. Interest rate cuts are a response to signs of weakness in the economy. That’s hardly good news. That perceived weakness is underscored by the Fed’s concurrent decision to prematurely end its asset reduction plan two months early.

That is, the Federal Reserve has decided to stop selling the bonds and other debt instruments it purchased during the several rounds of its Quantitative Easing policy to stimulate the post-2008 U.S. economy. The Fed’s decision to end its asset reduction plan tells us much about the Fed’s outlook for the U.S. economy.

The unemployment level, for example, is at a record low of 3.2 percent. In fact, all demographic groups are enjoying record employment levels. That’s certainly positive news. But it also means that the employment level can’t go much higher.

On the supply side, when labor is scarce—which it is—wages tend to rise, which they are. That’s also good news because wages have been flat—or negative—for the past decade. But will they rise enough to compare with, say, the inflation rate in housing?

Not likely.

Home prices, for instance have outpaced wages in key markets over the past decade. More about this in a moment.

The bigger picture is that the economy grew at 2.1 percent annualized rate in the second quarter of this year, which is positive as well. But most economic analysts project the growth rate to drop to around 1.5 percent in the third quarter. There are a few good reasons for this, even in light of Trump’s pro-business policies.

Conflicting Policies Hurt Business

Not surprisingly, the outlook among economists is mixed, as are the indicators. That’s fair, especially, given the crosscurrent of conflicting events and policies that are impacting the economy.

For instance, Trump cut corporate tax rates from 36 percent down to 21 percent. This initially boosted expansion activity as well as corporate profits. Drastic deregulation also reduced business costs, adding to efficiency and corporate profits. But its impact has been blunted by other factors.

The trade war with China – and the accompanying on-off-on again tariff strategy of President Trump – has played havoc with manufacturing supply chains and production cost projections. This, along with higher wages, has led to a rise in production costs for U.S. companies, somewhat offsetting the stimulus benefits of the tax cuts.

Also, slowdowns in demand from Europe and China, due in part to the trade war, have hurt American manufacturers. As a result, the Manufacturing Purchasing Managers’ Index fell from 50.6 in June down to 50.4 in July, the lowest since 2009. Even though an index reading over 50 indicates expansion, we’re seeing a tottering if not slowing trend in manufacturing activity.

That said, we live in a relative world. Compared to the Eurozone, China and Japan, the U.S. manufacturing sector as a whole is in better condition. The relative strength of the U.S. economy has kept the dollar strong compared to other major currencies. This, too has hurt U.S. manufacturing, as dollar-based American products are more expensive and therefore less competitive against those priced in weaker currencies with economies with weaker demands for manufactured goods.

A Little Cut Won’t Help

Given the factors above, the impact of a rate cut will be less than usual in the manufacturing sector. The trade war is a much bigger part of the equation. Some also see the economy at large as much less likely to react to lowering borrowing costs this time around, especially in the very important housing sector.

Those stagnant wages mentioned earlier are a critical factor in why marginally lower mortgage and credit card interest payments won’t really change the housing market much, either. The majority of borrowers have already reached their credit limits on unsecured debt. Consumer debt stands at around $14 trillion, surpassing the $13 trillion level reached just prior to the Great Recession. One could view that as either a sign of consumer confidence – or desperation.

What’s more, housing inflation continues to outpace wages in 80 percent of U.S. markets. According to the Zillow Home Value Index, nationwide, average home prices have risen over 150 percent from 2012 to 2019 and are projected to continue rising. That’s not a sustainable situation for the housing market. On the plus side, from 2010 to 2019, homeowner equity has grown from $75,000 to $171,000. That’s real wealth, some of which will be pumped back into the economy over time.

Consumer demand for housing is there, but many potential buyers are simply priced out of the market. Or, due to rising costs of labor and material, homebuilders are priced out of building them.

So it’s unlikely this small rate cut will motivate already tapped out consumers to buy more houses or other things. If employment continues strong, however, this need not be a problem.

James Gorrie is a writer based in Texas. He is the author of “The China Crisis.”

 

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.

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