Speculation is running high regarding whether the Federal Open Market Committee (FOMC) will cut interest rates – either the Federal Funds Rate upper bound or more importantly, the interest rate on reserves– at its next meeting scheduled for July 30 and 31. Opinions are split on what the FOMC should do, and what they will do. We have argued that they should have cut rates at their June meeting, and here we provide ten reasons to cut rates at the July meeting.
1. The Labor Market - Unemployment
. Despite the low unemployment rate, the labor market is not showing signs of extraordinary tightness. Certainly, the unemployment rate is very low, 3.67%, near its lowest level in fifty years. But unemployment is only part of the story. During the last recession, the labor force participation rate fell dramatically and has only recovered about half of the decline. Many workers exited the labor market and became part of a semi-permanent type of unemployment that is not captured by the unemployment rate. If we look at the employment rate, the ratio of employment to population, the percent working is 60.6%, well below the 63% achieved in 2007 before the recession, or the 64.7% achieved in 2000. Employment has room to continue growing - there are potential workers who exited the labor market as a result of the last recession and who are gradually rejoining the labor market. These new workers are relieving the pressure on the labor market caused by a booming economy.
2. The Labor Market - Wages.
While wages are not skyrocketing, average hourly earnings of all employees in the private sector increased 7.4% from January 2017 until June 2019, an annualized rate of 2.9%. This is an acceleration over the prior 30 month period (July 2014 – December 2016) when wages grew at only a 2.4% annual rate. This acceleration in wage growth also occurred in inflation-adjusted wages. The rate of inflation- adjusted wage growth increased from a 1.07% annual rate during July 2014 - December 2016 to a 1.51% annual rate during January 2017 – June 2019. This modest acceleration in wage growth signals that many workers are finally seeing more in their paycheck, certainly a good thing, but it is hardly a symptom of extraordinary tightness in the labor market.
3. Inflation is Below Target.
The Fed has a 2% per year inflation target. The Fed says it prefers to measure inflation with a PCE deflator that excludes food and energy prices, a measure of core inflation. Yet, the Fed has hardly ever managed to hit its inflation target since the last recession. Since 2009 the Fed has managed to get inflation (slightly) over 2% only in the months of December 2011 – March 2012. More often, the Fed has fallen well short of its target. In May, the year-over-year inflation measure was 1.4%.
4. The Fed – An Interest Rate Follower, Not a Leader.
During the period of rising interest rates from July 2017 through October 2018, the Fed followed interest rates up as it increased the interest rate on excess reserves (IOER). It seems that the Fed was not so much determining interest rates as following their upward trend. Since the end of 2018, interest rates have been declining, yet the Fed has so far declined to follow interest rates down. Over this six-month declining interest rate period the Fed has only made one small cut of 0.5% in the IOER. It is interesting to note that during this period, market interest rates have fallen despite the Fed holding IOER almost constant.
5. The U-Shaped Term Structure of Interest Rates.
In addition to the falling interest rates, since November of 2018 the term structure of interest rates has become partly inverted. Interest rates on medium-maturity Treasury securities have fallen below rates on short term Treasury securities. Since the end of 2018, interest rates have been falling across the maturity spectrum. Finally, for all but the longest maturities, interest rates on treasury securities are below the IOER. The Fed seems unable to move interest rates at this time.
6. Falling Federal Reserve Contributions to the Treasury.
The Fed buys securities, mostly U.S. Treasury securities but also Mortgage-Backed Securities, and at the same time the Fed pays banks interest on their reserves. When the Fed buys securities it creates reserves and receives the income from the security purchases. When the interest rate on the Fed’s holdings of treasury securities exceeds the interest rate the Fed pays on reserves, the Fed earns a net income which largely reverts to the U.S. Treasury. These transfers peaked at almost $100 billion but are steadily falling and were $65.4 billion in 2018. The future of such transfers is bleak as at present market interest rates, the Fed will be ‘losing money’ on new purchases of treasury securities with maturities below 20 years. This reduction in the amount of funds the Fed contributes to the Treasury will lead to somewhat higher federal deficits.
7. The Focus Must Be On the IOER.
When speaking of the Fed setting interest rates, the press concentrates on the Fed’s upper bound target for the effective Fed Funds rate. This is unfortunate, although certainly encouraged by the Fed. The rate that now matters for policy is the interest rate on excess reserves, the IOER. The IOER determines the effective Fed Funds rate, in that the Fed Funds supplied in the upper end transactions in the Fed Funds market come from member banks and occur at rates above the IOER. Since early June, over 75% of transactions in the Fed Funds market have occurred at rates above the IOER. At these rates member banks participate in the Fed Funds market and earn a profit lending funds at rates above IOER. Further, given the availability of Fed member bank excess reserves, over $1.3 trillion, and the scale of the Fed Funds market, less than $80 billion, the IOER will be the dominant factor in the effective Fed Funds rate.
8. The Economy Needs A Pro-Growth Money Supply.
All aspects of the economy indicate that an expansionary monetary policy is called for and that means that the Fed should be ensuring that the money supply increases. This expansion depends on the movement of bank funds out of excess reserves and into the economy. Banks are incentivized to hold excess reserves because they earn interest on those reserves, and currently that interest rate exceeds the rate on comparable short-term treasury securities. Reducing the IOER will encourage banks to reduce their holdings of excess reserves and will expand the money supply. For the period of rising interest rates the average spread between the rate of interest on 10-year treasuries and the IOER was 101 basis points. Now it is -22 basis points! Moreover, Fed net assets, the base for the money supply, are continuing to fall. Since May 1, these net assets have fallen by more than $140 billion as Fed securities holdings have fallen by over $100 billion and bank excess reserves have risen by $40 billion.
9. The Market Expects a Cut.
The Federal Funds Futures trading indicates that the market expects the average effective Federal Funds rate to be 2.055% in August. Currently, the IOER is 2.35%, the upper bound on the Federal Funds rate is 2.5%, and the effective Federal Funds rate has averaged 2.405% in July. The market is expecting a cut on the order of 0.35% in the effective Federal Funds rate. Any cut less than this will, in essence, be a surprise ‘tightening,’ and any cut over this will be a surprise ‘loosening,’ of monetary policy.
10. A Reduction in the IOER Is Way Overdue.
A substantial reduction in the IOER is necessary to achieve the Fed’s 2% inflation goal. Even a 50 basis point reduction in the IOER will only make the 10-year treasury-IOER spread a plus 28 basis points. Clearly it is time for the Fed to recognize that it must respond to the decline in market interest rates and reduce the IOER.