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Why Does the Fed Need to Help a “Good” Economy?

Oct 12, 2019 | Kevin Troy |

Why Does the Fed Need to Help a “Good” Economy?

We are being told by Federal Reserve Chair Jerome Powell that our economy is “in a good place.” Some even go as far as saying that the US economy is the best in history.

In reality, neither is more than a very optimistic appraisal.

In 2018, the Fed raised the benchmark interest rate four times before doing a 180 in January this year, advocating for “patience.” They quickly shelved that approach and returned to adding more stimulus, lowering the federal funds rate in July and September.

The Fed lowered the rates not to improve economic conditions but to prevent them from weakening due to slowing global growth, a continual trade war, and low inflation. Put simply, the Fed suggests that reinforcements are necessary to maintain the economy’s “good place” right now.

In fact, at an event last week, Powell opened with these words: “Our job is to keep it there as long as possible.”

The big question, however, is this: When maintaining a good place requires more than our central bank can offer via traditional means of financial stimulus (reduced short-term rates), what can the Fed do?

Compared to other developed countries, US interest rates are higher, but the federal funds rate is quite low (between 1.75% and 2%), and the CME Fed Watch Tool expects another 25-basis-point drop at the end of October.

The nominal overnight rate has, historically, been reduced by an average of 5 percentage points to fight recessions. With today’s low rates, that band-aid is unavailable.

With lower positive rates out of the picture, the Fed will have to look to its other tools. Quantitative easing and negative rates are returning to the table, although they are both being reassessed in terms of effectiveness and possible negative side effects.

So, is the economy good right now? Well, it’s not quite the greatest in our history, but some statistics do support the notion that our economy is pretty good.

  • The unemployment is at a 50-year low at 3.5%,.
  • The unemployment rate for African Americans and Hispanics is at a record low. (The Bureau of Labor Statistics began breaking out the numbers for these groups in the 1970s.)
  • The average hourly earnings for production and nonsupervisory workers increased by 3.5% in September year-over-year, almost at the post-recession high set in August.
  • The prime-age employment-to-population ratio jumped to 80.1%, which is the highest in two decades.

The most widely accepted measure of economic health, however, is GDP. While GDP growth is solid, it doesn’t measure up to many of his predecessors’.

Since January 2017, real GDP has grown 2.6% on average. This beats President Obama’s 1.9% average but fades when compared to the 3.8% seen under President Clinton, the 3.6% under President Reagan, and the 5.2% under Presidents Kennedy and Johnson.

Over the past years, the actual growth rate has been limited by a reduction in the potential growth rate, which is the rate at which the economy can expand without creating inflationary pressures. It is determined by the growth in the labor force and in productivity.

According to the Fed and the Congressional Budget Office, the potential growth rate dropped to around 1.8%. This might be as good as it gets until productivity growth is somehow lifted from its 1.4% average since 2004.

The “good place” is also threatened from abroad. The trade war with China has upset global commerce, disrupted supply chains, and pushed global manufacturing into recession. Meanwhile, protests in Hong Kong are impacting businesses, Middle East tensions and turmoil are rising, and the Brexit uncertainties are still dominating Europe.

Domestically, General Motors’ production is being delayed by the ongoing strike, and Boeing’s sales are imploding due to the 737 MAX ordeal. We are also seeing signs that the drop in US manufacturing is starting to seep into the services sector. And, of course, we cannot ignore domestic politics—the impeachment inquiry is distracting Congress from being productive. With all that in mind, “the greatest economy in US history” is on shaky ground. Even the Fed’s “good place” is being challenged. Since it seems that the economy is good right now, and since none of us can rely on the good times to last indefinitely, the only issue is this: What will the Fed do when things “go south”? Using the Fed’s arsenal of tools when things are good, and not having them to deal with a recession is something any investor should be concerned about.