The Fed's Credibility Dilemma

The Fed is entering uncharted waters as it debates the merits of interest rate cuts after ten years of economic expansion.

Robert Spendlove and Joseph Mayans Jun 27, 2019

The Story

The Federal Reserve appears to be on track to do something it hasn’t done in more than a decade – cut interest rates. After ten years of economic expansion, the US economy is showing signs of weakness and Fed officials are looking to act preemptively in order to prevent further deterioration. But the path forward for the nation’s central bank is anything but easy. In recent months, the president has ramped up his criticism of Fed officials and their rate setting decisions, calling into question the Fed’s ability to act independently of political pressures. Additionally, the Fed’s own policy tools, the federal funds rate and balance sheet, haven’t recovered enough from the Great Recession to provide a meaningful boost should the economy take a sharp turn for the worse.

Can the Fed Remain Credible?

The Fed is entering uncharted waters and its credibility as a trusted institution is under threat. The president’s attacks against the Fed and Chairman Powell for keeping rates “too high” have put the central bank in a precarious situation. If the Fed lowers rates, the decision will likely be seen by some as a capitulation to political powers, while at the same time validating the president’s critiques. If the Fed doesn’t cut rates or move aggressively enough, and the economy makes a turn for the worse, it will face increased scrutiny from the White House and the public for not acting earlier. 

The Fed has been under growing pressure from the White House to cut rates. The president has often tweeted his frustrations.

Tweets from President Trump
Source: Twitter account of @DonaldTrump

Perhaps the greatest threat facing the central bank’s credibility is its lack of policy-tool firepower. With its primary tool, the federal funds rate, sitting in a range between 2.25 and 2.50 percent, the Fed’s ability to cut rates to stimulate the economy is limited. Without much room before rates hit zero, the Fed will likely turn to its balance sheet for additional stimulus. However, the Fed’s balance sheet is still bloated from years of asset purchases during the crisis era, and it is unclear if the renewed use of this “unconventional” tool would be accepted by Congress or the public.

In each of the last three downturns, the Fed was forced to cut rates at least five full percentage points. And after dropping rates to near-zero in 2008, the Fed had to turn to its balance sheet to make large-scale asset purchases (QE) in order to provide further stimulus.

Graph of Fed Funds Rate
Source: Federal Reserve Board of Governors

When the Fed could no longer cut rates in 2008, it made three rounds of asset purchases (QE), which ballooned its balance sheet from roughly $800 billion to $4.5 trillion. The balances sheet still sits around $3.5 trillion.

Graph of Fed Balance Sheet
Source: Federal Reserve Board of Governors

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