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Low unemployment, solid growth, steady inflation – of course the US needs an interest-rate cut

Against an economic background more traditionally associated with interest rate rises, the US central bank has just cut rates. John Stepek explains what’s going on at the Fed.

Federal Reserve Board Chairman Jerome Powell s ©  Chen Mengtong/China News Service/VCG via Getty Images

Jerome Powell: not a smooth-talking econo-politician

The US economy is growing. Unemployment is near record lows. Inflation is pretty much where the Federal Reserve America's central bank likes it to be, and appears to be rising. Wage growth is healthy, and also appears to be rising.

Oh, and the stockmarket is near an all-time high.

If you only had those facts to hand, what would you expect the US central bank to be considering doing next?

If you said, "raising interest rates", then give yourself a big gold star for your comprehension of economic theory.

And then give yourself a dirty big fat zero for your grasp of political reality.

This is not a struggling economy

Yesterday, against the backdrop of a US economy that to all outward appearances is reasonably healthy, alongside a stockmarket that is very close to record highs, the Federal Reserve cut interest rates by a quarter of a percentage point. The key rate is now sitting at 1.75% 2% (the Fed targets a "range").

Now if we went back in time to before the financial crisis of 2008 mangled everyone's risk perceptions, you might think that excessive. You might even wonder if that was akin to "spiking the punch bowl" by adding a bit too much cheap money fuel to the fire.

You might even have expected share prices to rocket given what is clearly an excessively mollycoddling central bank.

But you would of course, be wrong. Markets weren't over the moon at the Fed's rate cut. They were mildly disappointed. They didn't think it was enough!

Jerome Powell, the current Fed boss, is not a smooth-talking econo-politician like the ECB's Mario Draghi, and it shows. He hasn't got the hang of doing one thing and then undercutting it by promising the market something else (although he's getting better at this, judging by his performance last night).

But it's hard not to feel for him. At the end of the day, if the Fed was going by its mandate (full employment and 2% inflation, basically), then it's a case of "mission accomplished". Indeed, two of the Fed members who vote on setting rates voted against the cut, thinking it unnecessary. That said, one voted for a half-point cut.

What sparked the latest deflation panic?

So what's going on? There are a number of factors at play.

Markets have worked themselves into a frenzy about a looming recession. This is understandable, and in my view which as far as I can see, is not necessarily widely shared has been driven primarily by China and the eurozone.

China's growth has been slowing, and that was the case before the trade war kicked off (but the trade war has made things worse). China's slowdown has had the knock-on impact of battering every export-dependent economy in the world. You need only look at Singapore's GDP data to see that. More importantly, it's had a knock-on effect on Germany.

Germany is the most important eurozone economy. And the eurozone is the most fragile link in the global financial system. A recession in the eurozone raises questions about the state of the banking system, which in turn raises the spectre of a repeat of 2008. If you're worried that 2008 is going to happen again, you buy sovereign debt, and probably gold too.

None of this is directly linked to the US. But this fear of deflation has driven bond yields a lot lower generally, and helped to trigger the brief inversion of the yield curve, which in turn is a pretty decent recession indicator.

So you've got a market that's showing signs of being petrified by the prospect of another deflationary collapse, and is screaming out for the Fed the big daddy central bank to "do something!!!",even though the current economic data doesn't seem to show much sign of immediate danger necessitating such emergency action.

On top of that you have a president who is aggressively calling for rate cuts. But more importantly (because that's just showmanship), he's also pursuing an entirely unpredictable trade policy.

The reality is that what happens to global trade is pretty important for the Fed's decision-making. But the Fed can't really make its decisions based on the idea that Donald Trump might decide to tweet about raising tariffs at lunchtime.

A messy but likely effective compromise

So what did we end up with?

A messy compromise, really. Powell did the minimum that the market was demanding, in that if he hadn't cut rates, you'd probably have seen a proper slide in stocks.

But he also clarified during his press conference that we shouldn't pay attention to what the various Fed members think will happen to rates in the longer run (the so-called "dot plot", which has always been a waste of time, and not something I've talked about much in Money Morning as a result).

In other words, he's kept his options open. If the market needs more rate cuts or liquidity or whatever, he'll deliver it.

Meanwhile, Draghi's swan song over at the European Central Bank has probably taken the edge off the deflationary panic. As a result, even though markets aren't exuberant enough to fall for a blatant flop like WeWork, I would not be surprised to see new highs for US stocks before Christmas.

But keep an eye on the US dollar. That's still key to all of this. We'll look at that in more detail in Saturday's Money Morning.

And just a reminder before I go get your tickets for the MoneyWeek Wealth Summit 22 November, central London, don't miss it. You can check out the agenda so far here.

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