Mandatory Credit: Photo by SHAWN THEW/EPA-EFE/Shutterstock (10315534m) US Federal Reserve Board Chairman Jerome Powell responds to a question from the news media during a press conference after a Federal Open Market Committee meeting in Washington, DC, USA, 19 June 2019. Powell announced that interest rate will not change. A day earlier, President Trump raised the issue of possibly firing Powell but Chairman Powell has said he would not step down and that he plans to serve his full term through February 2022. US Federal Reserve Board Chairman Jerome Powell announces no interest rate change, Washington, USA - 19 Jun 2019
Jay Powell, the central bank's chairman, warns that lower rates could undermine financial stability

The US Federal Reserve’s more dovish stance on Wednesday ratifies conventional wisdom about what is appropriate monetary policy. But its openness to cutting interest rates was never the most important issue. Investors should instead be asking: rate cuts to what end? Lower borrowing costs may not accomplish much, and if the Fed fails to invigorate growth and inflation, its credibility may be severely undermined.

Policymakers face two issues: slowing growth could presage a recession, and they have been unable to push inflation up to their 2 per cent target. Conventional economic theory says reducing rates should help both, by boosting confidence and encouraging borrowing. The increased economic activity should stimulate inflation.

But the main drag on growth today is not the cost of borrowing, and seven years of zero interest rates after the financial crisis failed to bump up inflation to the Fed’s target. Consumer confidence remains strong, with the University of Michigan and The Conference Board surveys showing it is near post-crisis highs.Retail sales have rebounded in the past two months. The Fed has raised rates nine times since 2016, and consumer credit demand is still well above its post-crisis average.

Instead, the economy’s weak spot has been business investment, but not because of the cost of capital. Companies have put expansion plans on hold because of US president Donald Trump’s rethink of trade policy. Concerns about tariff-related costs and supply chains have dragged down chief executive confidence and that shows in lower spending. Orders for non-defence capital goods excluding aircraft, a proxy for business investment, fell in April by the most in five months.

Mr Trump’s recent tweets threatening tariffs on Mexico helped stoke rate-cut demands. But the Fed cannot influence trade policy and the effects of monetary policy moves might kick in after tariffs have been avoided. It is not clear that consumption and investment would rise materially this late in the economic cycle. The Fed’s most recent Senior Loan Officer survey suggests demand for autos is softening. Residential mortgage rates have been falling since October and rates on 30-year fixed mortgages are back below 4 per cent.

There is also a risk rate cuts would undermine the Fed’s efforts to maintain financial stability. Equity markets are near record highs. The Fed could make it easier for companies to roll over their debt and save money — but lower rates would also boost risky debt issuance, something the central bank chairman Jay Powell recently warned about.

Low or falling inflation is the Fed’s other concern. Policymakers worry inflation expectations are becoming detached from other market signals. The inflation rate the Fed targets, the personal consumption expenditure index, has risen only 1.5 per cent annually since the financial crisis. At their June meeting, officials forecast it would not reach 2 per cent until at least 2021.

As Dallas Fed president Robert Kaplan highlighted in a recent interview, monetary policy can address the cyclical drivers of inflation but not the structural ones. The latter factors muting inflation include technology-enabled disruption and globalisation. Both weaken business pricing power and improve consumers’ leverage. Rate cuts do little to combat these trends.

If Fed cuts fail to reinvigorate growth and inflation, the central bank’s credibility may be undermined ahead of the next downturn. Without credibility, the Fed risks becoming ineffective. Analysts already worry whether the central bank has enough tools to fight the next recession. If investors don’t believe the ones it does have will work, the Fed will head into that fight with both hands tied behind its back.

The writer is an incoming senior fellow at the Harvard Kennedy School.

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