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Why the Federal Reserve is ready for its first interest rate cut since the crisis



The Federal Reserve on Wednesday is broadly expected to cut interest rates for the first time in more than a decade, even as economic expansion in the United States reaches record lengths, unemployment hovers at historic lows and consumers continue to use.

Uncertainty surrounding global growth and sustained low inflation are behind the expected move, as both pose major threats to the health of the economy at a time when the central bank has limited ammunition to fight a downturn. This will be what is called an "insurance cut" ̵

1; one that central bankers do to continue growth.

Inflation – a key indicator – has been too slow.


Inflation




+ 1.6%

Core PCE

(excluding food

and energy)

2008-9 global

financial crisis

+ 1.6% [19659006] Core PCE

(excludes food

and energy)

2008-9 global

financial crisis

+ 1.6%

Core PCE

(excludes food

and energy )

2008-9 global

financial crisis


Annual change in price index for personal consumption (PCE) | Source: Bureau of Economic Analysis

The Fed's most important jobs are to maintain maximum employment and stable inflation. Officials have long been aiming for 2 percent as the sweet spot for prize winnings. Low inflation is good because it provides a buffer to prevent prices from falling in times of slow growth. Fair deflation is dangerous because it causes consumers to hoard cash, knowing that goods and services will be cheaper tomorrow.

problem? Inflation has not reached the goal of sustainability since the Fed formally adopted it in 2012.

Stubbornly low inflation has also increased the risk that expectations for future inflation will decline.


Inflation expectations





A measure of expected inflation (on average) over the five-year period beginning five years from today. | Source: Federal Reserve Bank of St. Louis

It can create a self-fulfilling prophecy, because companies that expect low inflation can set their prices accordingly.

Although slow price gains may sound good, they can make it more difficult for employers to raise wages. Beyond that, the Fed's policy rate includes price rises, so weak inflation leaves the Fed with less room to cut interest rates should the economy fall.

Politicians want to get ahead of a global economic downturn.

Concerns for the path of the global economy have developed. The trade war, a downturn in China and a weakening that spans many advanced economies can all contribute to the growing anxiety.


Global Economic Policy Index of Uncertainty





Sept. 11, 2001

terrorist attack

2008-9 global

financial crisis

Eurozone crises,

U.S. debt-ceiling crisis,

China leadership transition

European

immigration

crisis

Trump elected

U.S. president

Political unrest in Brazil,

France and South Korea;

U.S. trade war

Political unrest in Brazil,

France and South Korea;

U.S. trade warrior

Trump chose

U.S. president

Euroson crises,

U.S. debt-ceiling crisis,

China leadership transition

2008-9 global

financial crisis

sept. 11, 2001

terrorist attack

European

immigration

crisis

Political unrest in Brazil,

France and South Korea;

U.S. trade warrior

Trump chose

U.S. president

Eurozone crises,

U.S. debt-ceiling crisis,

China leadership transition

2008-9 global

financial crisis

sept. 11, 2001

terrorist attack

European

immigration

crisis

sept. 11, 2001

terrorist attack

2008-9 global

financial crisis

Eurozone crises,

U.S. debt-ceiling crisis,

China leadership transition

European

immigration

crisis

Trump elected

U.S. president

Political unrest in Brazil,

France and South Korea;

U.S. trade wars


A G.D.P.-weighted average of national indices for the frequency of newspaper articles in each country discussing uncertainty in economic policy. | Source: Scott Baker (Northwestern Univ.), Nick Bloom (Stanford Univ.) And Steven Davis (Univ. Of Chicago)

At a time when inflation is already low and interest rates do not have much room to fall, politicians want to come ahead of all the shocks that could disrupt US growth.

Production is an area where growing concerns can bleed into real economic activity. Indexes that track production in many advanced economies slow down or contract. While services account for an increasing share of G.D.P., factory progress is a good financial warning signal: it slows down earlier than other industries when activity declines. Fed officials have been monitoring the sector alarmingly.


Index of Purchasing Managers





A measure of production including production, orders, inventory and other factors. * Data through July, all others through June. | Source: IHS Markit, via FactSet

Unemployment is often low right up until a recession, so it is a poor guide for Fed policy makers.

While inflation, global uncertainty and hints of slowing economic activity have pushed the Fed to the brink of cuts, there are good reasons why officials are yet to forecast a full interest rate cut that puts the policy setting at near-zero. Consumers are still using, the labor market is growing and production is still strong.

But all of these data points respond to financial decline with a delay.


Unemployment





(Includes unemployed and

people who are interested in working,

but who are not actively seeking *)

(Includes unemployed and

people who are interested in working,

but not actively seeking *)

(Includes unemployed and

persons interested in working,

but not actively seeking *)

(Includes unemployed and

persons who are interested in working,

but who are not actively seeking *)


* Total unemployed, plus all persons marginally linked to the workforce, plus total part-time employment for economic reasons, as a percentage of the civilian labor force plus all persons which is marginally related to the workforce. | Source: Bureau of Labor Statistics

Unemployment is not decisively higher until just before, and sometimes a few months after the beginning of a recession. As a result, central bankers seem to think this is the time to get moving – waiting and watching may come later, when the economy has had some juice to fall back on.


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