The Federal Reserve cut interest rates. It didn’t loosen monetary policy.

  • By Matthew C. Klein,
  • Barron's
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The Federal Reserve lowered its target band for short-term interest rates by a quarter percentage point to 1.75%-2%, representing a compromise between policy makers who wanted to lower rates even further and those who wanted to avoid any changes at all.

More significant is what Fed officials implied about the future.

Wednesday’s “summary of economic projections” (left, below) shows a plurality of officials—8 of 17—expect the policy band to be 1.5%-1.75% by the end of 2020 before gradually increasing in subsequent years. Back in June (right side), when the Fed last published its forecasts, no one thought rates would drop below 1.75%, while the majority—10 of 17—expected short-term rates to be above 2% by the end of 2020.

At first blush, this looks like a situation where the Fed has loosened policy. It is not. Instead, it is simply the next step in the “midcycle adjustment” of monetary policy that began at the start of the year, as Fed Chairman Jerome Powell has put it.

What matters is not the level of interest rates, but the level of rates relative to economic and financial conditions. Sometimes short-term interest rates of 2% are too high to keep spending and borrowing on stable trajectories, just as there can be circumstances when rates at 5% are too low. This means that changes in interest rates, by themselves, don’t indicate whether policy has loosened or tightened.

The Fed’s official explanation of its forecasts makes this clear. All of the projections for growth, unemployment, and inflation are “based on [Fed] participants’ individual assessments of appropriate monetary policy.” In other words, they are targets that determine where interest rates should go.

Those targets haven’t changed even as interest rates have dropped. As I wrote earlier this week, “the central bank did not become more ‘hawkish’ or ‘dovish’ over the past year. … Instead, officials simply concluded that the ‘neutral’ level of interest rates—where they neither spur nor slow growth—was lower than they previously believed and are responding accordingly.”

The latest projections indicate most (but not all) officials want sub-2% GDP growth, slightly higher unemployment, and inflation to remain slightly below the 2% target for several years.

This is not loose monetary policy—at least, not on purpose. The more interesting question is whether policy is too tight. The answer depends on the mixed signals coming from the shape of the yield curve as well as how one interprets the complex links between short-term interest rates, the broader financial system, and the spending and borrowing decisions of everyone else.

The next scheduled Fed meeting will be on Oct. 29-30 and the next set of projections will be published on Dec. 11. The Fed will likely cut rates again at one of those meetings. If not, keep an eye out for an explanation.

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