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Why the Federal Reserve is ready for its first cut in interest rates since the crisis



It is widely expected that the Federal Reserve will cut interest rates on Wednesday for the first time in more than a decade, even though economic expansion in the United States is record-breaking, unemployment is at historically low levels and consumers continue to spend.

Uncertainty about global growth and persistently low inflation is behind the expected trend, as both jeopardize the health of the economy at a time when the central bank has limited ammunition to prevent a downturn. It will be a so-called "insurance cutback" ̵

1; one that central bankers are doing to drive growth.

Inflation – a key indicator – was too sluggish.


Inflation




+ 1.6%

core PCE

(excluding food

and energy)

global

financial crisis

+ 1.6%

core -PCE

(excluding food

and energy)

2008-9 worldwide

Financial Crisis

+ 1.6%

Core PCE

(excluding food

and energy )

2008-9 Global

Financial Crisis


Annual Change in Price Index for Personal Consumption (PCE) | Source: Bureau of Economic Analysis

The main task of the Fed is to maintain maximum employment and stable inflation. Civil servants have long been aiming for 2 percent as a sweet spot for price gains. Low inflation is good because it provides a buffer to prevent prices from falling in times of slow growth. Complete deflation is dangerous because consumers need to hoard cash, knowing that goods and services will be cheaper tomorrow.

The problem? Inflation has not sustained the target since the Fed officially adopted it in 2012.

The stubbornly low inflation has also increased the risk that expectations of future inflation will decline.


Inflation expectations





A measure of expected inflation (on average) over the five-year period beginning five years from today. | Source: Federal Reserve Bank of St. Louis

This could lead to a self-fulfilling prophecy, as companies expecting low inflation may set their prices accordingly.

While slow capital gains may sound great, they can make it harder for employers to raise wages. In addition, the Fed's interest rate raises prices so that the Fed's weak inflation leaves less room for interest rate cuts should the economy collapse.

Politics wants to be one step ahead of a global economic slowdown.

Concern about the development of the world economy has increased. The trade war, a slowdown in China, and a slowdown spilling over many advanced economies could compound the growing concern.


Uncertainty Index for World Economic Policy





Sept. 11, 2001

Terrorist attacks

2008-9 global

financial crisis

crisis in the euro area,

USA. Debt crisis,

Transition of Chinese leadership

European

immigration

crisis

Trump elected

USA. President

Political unrest in Brazil,

France and South Korea;

United States. Trade wars

Political unrest in Brazil,

France and South Korea;

United States. Trade wars

Trump elected

USA. President

Crisis in the Eurozone,

USA. Debt upper limit crisis,

transition of the Chinese leadership

2008-9 global [19659907] financial crisis

Sept. 11. 2001

Terrorist attacks

European

immigration

Crisis

Political unrest in Brazil,

France and South Korea;

United States. Trade wars

Trump elected

USA. President

Crisis in the Eurozone,

USA. Debt upper limit crisis,

transition of the Chinese leadership

2008-9 global

financial crisis

Sept. 11, 2001

Terrorist attacks

European

immigration

Crisis

Sept. 11, 2001

Terrorist attacks

2008-9 global

financial crisis

crisis in the euro area,

USA. Debt crisis,

Transition of the Chinese leadership

European

immigration

crisis

Trump elected

USA. President

Political unrest in Brazil,

France and South Korea;

United States. Trade Wars


A GDP-weighted average of the national indices of the frequency of newspaper articles in each country where economic policy uncertainties are discussed. | Source: Scott Baker (Northwestern University), Nick Bloom (Stanford University) and Steven Davis (University of Chicago)

At a time when inflation is already low and interest rates are not much room for maneuver, policymakers ahead of shocks that could disrupt American growth.

The manufacturing sector is an area where growing concerns could affect real economic activity. Indices that track, slow or shrink production in many advanced economies. While services account for a growing share of G. D. P., the progress of the factories is a good economic warning sign: it slows down earlier than other industries when activity slows. Fed officials have been concerned about the sector.


Purchasing Managers Indices





A measure of the manufacturing sector, including production, orders, inventories and other factors. * Dates until July, all others until June. | Source: IHS Markit, via FactSet

Unemployment is often low until a recession and therefore a poor guide to Fed policy.

While inflation, global uncertainty and signs of slowing economic activity have pushed the Fed to the brink of cuts, there are good reasons why officials still do not predict a sweeping interest rate cut cycle that will bring the policy framework closer – Zero. Consumers are still spending, the labor market is growing and production remains strong.

However, all of these data points are lagging behind in terms of economic slowdown.


Unemployment





(Including unemployed and

employed persons,

but without active application *)

(Including unemployed and

employed persons,

but without active application) *)

(Including unemployed and

interested in work,

but not actively applying *)

(Including unemployed and

interested in work,

but not actively applying *)


* Total number of unemployed plus all marginal the number of persons employed, plus part-time workers employed for economic reasons, as a percentage of the civilian labor force plus all persons marginally tied to the labor force. | Source: Bureau of Labor Statistics

The unemployment rate is rising significantly, just a few months before and sometimes a few months after the onset of a recession. For this reason, central bankers seem to think that this is the time to move – waiting and observing can happen later, when the economy has some extra juice to draw on.


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