Adam Ozimek, chief economist at Upwork
The Federal Reserve lowered interest rates by 25 bps in September to a range of 1.75% to 2.0%. This is their second interest rate cut in recent months, and is on par with expectations. Multiple factors have led to the Fed’s pivot to a more dovish stance over the last year. One of the most pressing factors is that the Fed sees an elevated risk of a recession. Given that rates are already low, they’d rather cut early to prevent a downturn than cut late and risk hitting the zero lower bound. The other factors are slower moving. First is the stubborn inability of inflation to sustainably hit the target of 2%. Second is the closely related trend that the economy is not yet at full-employment. More than the risk of a recession, these slower moving factors provide a stronger basis for cutting rates and are more consequential for understanding the economy today.
It’s true that economic headwinds like the trade war and weak global growth have become significant enough to slow the US economic recovery. While cutting sooner rather than later is a prudent, the current headwinds are not enough to throw the economy into recession, a risk which remains relatively modest. Instead, the more important reason to cut rates is that we are not yet at full-employment. Labor market slack, and the Fed’s consistent underestimate of it, goes a long way in explaining the troubling inflation trends and remains a main, consequential reason to cut rates.
While the challenges of the zero lower bound mattered for the beginning of the recovery, in recent years the failure to consistently hit target inflation is first and foremost a reflection of the Fed’s failure to gauge how far the economy has to improve and set rates and rate expectations accordingly. In addition, that we are not yet at full-employment is an important context for understanding other macroeconomic issues. For example, it helps to understand why wage growth remains modest. It also has potential consequences for the housing market, which remains a missing piece of the recovery. If labor markets have yet to recover, it is less surprising that housing markets have not either. Trade uncertainty is important, and is holding back the economy, but it cannot explain why inflation has remained below target and the economic recovery remains incomplete after so long. Fed Chair Powell has recently said
“The current U.S. expansion has entered its 11th year and is now the longest on record,”
however a less generous description would be
“the recovery has now taken over a decade.”
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