New York (CNN Business)The Federal Reserve is preparing to rescue the American economy from President Donald Trump’s trade war.
Fearing a recession and soft inflation, the US central bank has signaled it will cushion the blow from tariffs by lowering interest rates.But there remains a deep divide over the wisdom and merits of this rescue effort. Some believe the Fed is taking out prudent insurance designed to prevent a deflationary spiral and extend the economic recovery long enough to normalize policy. “It’s very important this expansion continue as long as possible,” Fed chief Jerome Powell told lawmakers on Thursday as he strongly hinted at rate cuts.Others point to historically low unemployment and the Dow cruising above 27,000 as evidence that the Fed is making a major blunder. Unnecessary rate cuts risk blowing yet another asset bubble, overheating the economy and leaving the Fed with little ammo to fight an actual recession.
It will not stimulate the economy in any way."
Read More”It’s a mistake to do it now,” David Kelly, chief global strategist at JPMorgan Funds, told CNN Business. “Serious rate cuts are like the fire extinguisher: You only break the glass when you really need to.”Using up half the Fed’s ammoThe controversy is being fanned in part by how fast the Fed has morphed from hawkish to dovish — and how much pressure Trump has placed on the central bank to do just that. Just last year, the Fed raised interest rates four times — and signaled another three or four more hikes in 2020. The rate hikes successfully slowed the booming economy, keeping inflation in check, and finally moved the Fed away from the zero level that many feared it was stuck at. Raising rates during good times makes sense because it gives the Fed room to cut during bad times.Inflation may be creeping higher after allBut the rate hikes may have gone too far in an economy long-accustomed to free money and coping with a confidence-sapping trade war.Now, the Fed has reversed course — rapidly. For context, consider that late last year Bank of America projected the Fed funds rate would climb toward 3.4% by 2020. Now, Bank of America is forecasting three rate cuts down to 1.6%. That’s quite the shift. “Relative to the old baseline, the Fed is now expected to use up half of its conventional policy ammunition,” Ethan Harris, head of global economics at Bank of America Merrill Lynch, wrote in a note to clients on Thursday. Harris pointed to evidence that the trade war has hurt the economy, including sinking business confidence, “sharply” slowing manufacturing activity and a contraction in trade in all major regions around the globe except Eastern Europe. “The potential for rate cuts makes a recession less likely,” said Gus Faucher, PNC’s chief economist. Faucher estimates there is a better than two-thirds chance that the Fed successfully engineers a soft landing in the economy. Is inflation hot or cold? Depends on who you askTo make its case, the Fed has pointed out that its preferred inflation metric, the Personal Consumption Expenditures index, is badly missing the central bank’s self-imposed 2% target. It decelerated to 1.5% in May. While American shoppers never complain about low prices, central bankers fear deflation because it can turn into a spiral that’s difficult to escape. “The Fed wants to avoid a repeat of what happened to the Japanese economy,” said Erin Browne, a portfolio manager at PIMCO. She said that the weak PCE inflation, in a strong economy, suggest that rate cuts are “warranted.”However, other metrics signal healthy inflation levels. In June, consumer prices, excluding food and energy, climbed by the most month-over-month since January 2018. And it was the second-largest gain in core prices of the entire economic expansion, according to Bespoke Investment Group. Turkey is the poster child for what happens when politicians mess with central banksIt’s not clear how effective rate cuts will be, in part because interest rates remain historically low and mortgage rates have already plunged.”It will not stimulate the economy in any way,” said JPMorgan’s Kelly. “There is not a single business person in America who is hesitating to invest today because rates are too high.”Kelly even argued that rate cuts could backfire by encouraging people to delay borrowing in hopes of lower rates down the road. “Cutting rates at this level may hurt the economy more than it helps it,” he said. Bubble riskThe Fed may need to lower rates — even if it doesn’t want to — because Wall Street is banking on it. Failing to act now, after declining many chances to push back against the market, would cause a selloff that could infect the real economy.”They really put themselves in a box,” said Vincent Reinhart, chief economist and macro strategist at Mellon. Reinhart, a 24-year veteran of the Fed, suggested the central bank may need to slash rates by half a percentage point in the July meeting to get ahead of market expectations. “They could use it as a firebreak,” he said. Of course, there are risks to this strategy. Excessively low rates can lead to asset bubbles, like the ones that eventually popped in tech stocks in the early 2000s and the housing market last decade.”The Fed is a serial bubble-blower,” said Reinhart. Another risk is that inflation reawakens so much that the Fed needs to raise interest rates so rapidly that it drags the economy into a recession. “Inflation is going to come. The Fed will have to pivot again. And pivots are risky,” Reinhart said. Fed independence under siege The Fed’s abrupt moves have raised questions about whether Trump is influencing central bank policy. The president has repeatedly bashed his handpicked Fed chief and pleaded for lower rates.Powell has stressed that the Fed is independent and remains insulated from short-term political pressure. “I don’t think the Fed is at all being swayed by the president or by politics,” PIMCO’s Browne said.However, Reinhart said the political pressure has “influenced” Powell’s communication strategy, forcing him to “sound more tentative.” That in turn allowed the Fed to get backed into a corner.”The Federal Reserve’s independence is more threatened than ever before,” JPMorgan’s Kelly said, adding that political pressure may have a “little bit” to do with the willingness to cut rates.He compared it to a parent finally giving in to a child making a scene at a candy shop, just to maintain some order.”The Fed is trying to bend,” Kelly said, “to make sure its independence does not break.”