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.
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.
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.