Why is everyone obsessed with the Fed?
On Wednesday, the Federal Reserve did what everyone expected it would do, and what President Trump was straight-up demanding it do: The central bank cut interest rates.
And everyone promptly freaked out.
The stock markets took a tumble, with the Dow falling 1.2 percent, and the S&P dropping 1.1 percent. Experts more or less all agreed that Fed Chairman Jerome Powell botched his explanation of the central bank's decision. "Powell let us down" Trump blasted from Twitter.
How is it that the Fed can be at the center of everyone's attention, do what everyone expected (and wanted), and still somehow manage to piss everyone off?
On paper, at least, the explanation is that the Fed cut interest rates a modest 0.25 percentage points, but both the Fed's written explanation and Powell's press conference left everyone befuddled, by not laying out what was going to happen next. "Let me be clear: What I said was it's not the beginning of a long series of rate cuts," Powell explained on Wednesday. On the flip side: "I didn’t say it’s just one or anything like that." Basically, we think this rate cut is a good idea, but we don't know what we'll do next.
That's certainly what irritated Trump, who insisted that "what the Market wanted to hear" was that "this was the beginning of a lengthy and aggressive rate-cutting cycle." It would be more accurate to say that's what the president himself wanted to hear. But plenty of experts and financial insiders were equally put off. "I lost count of how many times he said 'uncertain' or he 'didn't know,' which is very disconcerting," Diane Swonk, the chief economist at Grant Thornton, told the Washington Post. "Powell increased uncertainty around the direction of policy," Scott Minerd, the chief investment officer at Guggenheim Partners LLC, complained to the Wall Street Journal. "The policy statement was ambiguous and frankly [Powell] hasn't done anything to clarify it," Ward McCarthy, the chief financial economist Jefferies, pronounced to CNBC.
Part of the problem here is a disconnect between what the Fed's job actually is and why much of the financial press bothers covering the central bank's decisions.
The Fed's responsibility is to American society as a whole; to maximize job and wage growth while also trying to keep inflation low and stable. The financial press, on the other hand, largely covers the Fed to provide information to the small-but-wealthy slice of the population that makes its money buying and selling financial assets. The Fed's ongoing interest rate decisions have a big impact on that game of financial arbitrage. As a Wall Street trader, it's always nice to know what the Fed will do well into the future. And it's annoying when the Fed doesn't give you that information.
The problem is when the financial press' coverage bleeds over into the assumption that the Fed's performance of its responsibilities can be assessed by how its decisions and communications affect investors. That's simply a category error. As I said, the Fed's responsibilities are to the broader economy. Its changes to interest rates affect that broader economy through millions of decentralized decisions about whether to start a business, buy a home, purchase a car, and so on.
On occasion, changes in investor class behavior — themselves in reaction to the Fed — do filter down to also alter those broader forces. But not that often. It's entirely possible for Wall Street to do well while the economy does poorly, and vice versa. When Minerd complained that "the discussion around the future path of interest rates was ham-handed and probably undid a lot of the benefit of the rate cut," he was ridiculously placing the investor class at the center of the universe. It just isn't so.
Another problem is that the Fed is caught in something of an existential crisis at the moment. Mainstream theories about the relationship between unemployment on the one hand, and wage growth and price increases on the other — theories which have long governed the central bank’s approach — have come apart in the last decade. As Neil Irwin observed in the New York Times, "There is less and less evidence to support the rationale for the earlier rounds of interest rate increases: that the economy was at risk of overheating and so higher rates were needed to forestall inflation."
On the merits, the Fed probably should cut interest rates a lot more — not because that's what Wall Street and Trump demand, but because it's justified by the underlying facts regarding wage growth, inflation, and inequality. As an institution, the Fed just isn't there yet. But it's current decision to try a rate cut, then wait and see what happens, is better than nothing. And it's certainly better than continuing on with its rate hikes.
Finally, a third problem is the broader conceptual policy framework the Fed is trapped in. The mainstream assigns the job of managing the economy to the central bank’s monetary policy, while it tasks fiscal policy under Congress with just keeping its books balanced. This is not actually a great division of labor, given the respective powers of monetary and fiscal policy. The end result is that Congress has chronically under-stimulated the economy for decades, leading to a long decay in the strength of economic growth. That's forced the Fed to drive interest rates ever lower to keep growth up.
If Congress were to commit to something like a $1 trillion public investment in national infrastructure, or a Green New Deal, that would give the Fed a much stronger economy to work with, while also lowering the relative importance of any one interest rate change. As it is, keeping fiscal policy on the sidelines puts monetary policy in a paradoxical position: The weakness of the economy leaves the Fed with less and less room to maneuver interest rates in the case of a downturn, while also magnifying the importance of every interest rate adjustment, no matter how minor.
Until that fundamental relationship between fiscal and monetary policy changes, the Fed will remain the biggest game in town. The attention of investors, politicians and journalists will remain fixated on its every twitch. And the Fed will almost certainly continue to fail to make anyone happy.