Will the Fed's rate cut matter?

Yesterday the Federal Reserve cut the federal funds rate from 2.50 to 2.25 percent.  Financial markets reacted adversely, perhaps because they anticipated a larger cut or the prospect of more cuts in the future.

But what economic impact will this cut in interest rate have?  Chicago Booth economist Austan Goolsbee questions whether it will do much at all.  Lower interest rates historically stimulate household purchases of durables (furniture, appliances, cars, homes) and corporate spending on investment.  Goolsbee points out that interest rates have been at historically low levels for 10 years, so there is not likely to be much pent-up demand for durable goods.  Also, rates cannot fall much further from their current rates; zero is a lower bound!  Banks are not going to pay borrowers interest.  

Long term rates are just as low as short term rates, indicating the market expects interest rates to remain quite low.  Proponents of the rate cut argue that slower growth in Europe and China dictates stimulus in the US.  However, the rate cut also led to the dollar raising in value to its highest level in two years (not what we would have expected, by the way; lower interest rates usually imply a declining currency value).  If this holds up, expect net exports to decline which will further slow growth.  Also the interest rate cut is bad news for savers.

Two members of the Fed's Open Market Committee voted to not make any change in interest rates, believing that an economy with 3.5 percent unemployment does not need any more stimulus.  If Goolsbee is right and the rate cut does not offset the drag from trade wars and slower growth in other countries, it will be interesting to see if the Fed doubles down on yesterday's action.

Starting to 2nd guess the Fed

NYT's Gretchen Morgenstern issued the first salvo I have seen in the mainstream media in her column today.  She openly questions the wisdom of keeping rates at near zero levels, given that (a) this is significantly penalizing savers and (b) very few people qualify for the low interest rates, especially for mortgages.  Isn't the whole idea of low rates to stimulate borrowing?  Don't get me wrong; I'm not drinking the Ron Paul Kool-Aid about abolishing the Fed, but some serious questions about its interest rate policy need to be raised in this year's campaign.  I give Ben Bernanke very high marks for his moves in 2008 and 2009, but I have real concerns about the Fed's stated commitment to keep rates low for as much as another two years.   

The problem with low interest rates

Raghuram Rajan, a finance professor at Chicago's b-school, explains the downside of near-zero interest rates today on NYT's Freakonomics website.  Rajan uses the following scenario to make a key point: suppose that instead of lowering interest rates the government instead decided to subsidize the price of another key input, say energy.  MBA 505 veterans can easily outline the adverse consequences: if the suppliers of energy do not get a subsidy they will shut down and if they do get a subsidy the costs to the budget are the same as traditional stimulus (tax cuts, government spending).  In financial markets the parallel is that either (1) lenders have little incentive to make loans with super-low interest rates and (2) the cost of low interest rates to savers is massive, perhaps on the order of $400 billion. 

Rajan points out additional distortions: too much borrowing will lead to future bubbles that once again will burst with lenders expecting another bailout.  He thinks the Fed should gradually begin to raise rates to 1.5 to 2 percent over the next year.  He also urges a rethink and expansion of programs that prepare workers for the jobs of the future (easier to say than to do, as any labor economist will tell you). 

My own take: low short term rates worked historically to shorten recessions by stimulating housing and consumer durables (such as cars, furniture).  One reason the stimulus is not working so well is that real estate and automobiles are going through structural transformations that will make these sectors permanently smaller.