Turning point on interest rates

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The Federal Reserve went for the big cut at its interest rate meeting this week. There was uncertainty on whether the federal funds rate would go down by a half percentage point or a quarter percentage point. The Fed went for the larger half point cut. By itself, this is not a big deal. The big deal is that the Fed is no longer focused solely on inflation.

Even though today's actions are small, they could mark a major turning point in America's monetary policy.

The Fed's Open Market Committee meets every six weeks. Members will likely make further cuts at its two remaining meetings this year. Those cuts can quickly add up, and could undo the Fed's hard-won gains on controlling inflation.

Part of the problem is that the Fed has two jobs. One is to keep inflation low. The other is to keep unemployment low. These are both good goals, but they can contradict each other. The Fed can choose one, or it can choose the other. But it cannot choose both.

Right now, it is trying to choose both. As a result, it risks getting neither inflation nor unemployment where it wants them to be. The reason is tradeoffs.

To get the post-COVID inflation back down, the Fed had to ignore the job market and focus only on inflation. High interest rates and tight money can get inflation down, but with a tradeoff: slower job creation and slower growth. That is why people were worried about the Fed sparking a recession by raising interest rates.

With unemployment still in good shape but creeping up the last few months, the Fed is turning its eye to the labor market. It can stimulate job growth by cutting interest rates, but with the tradeoff of risking higher inflation.

There are tradeoffs no matter what the Fed does. That is why it can have either low inflation or low unemployment, but not both.

The half point cut will strike some analysts as too much, especially with more cuts likely on the way. But there is one mitigating factor that will soften its effects: the Fed's balance sheet, which consists mostly of government bonds.

This balance sheet is a far more powerful monetary tool than interest rates, and should get far more attention than it does.

The Fed can directly adjust the money supply by buying and selling large amounts of government bonds. It can stimulate the economy by buying bonds. It buys them with money, which then circulates through the economy. Unlike you or me, the Fed can buy these bonds with money it newly creates. That is how the Fed directly grew the money supply during COVID, to the tune of $5 trillion. This balance sheet bonanza was far and away the biggest cause of the inflation we are still dealing with.

Since the Fed regained its senses, it has slowly been drawing down that balance sheet. It has been letting those bonds expire, and then retiring those dollars from circulation. The Fed's balance sheet peaked at about $9 trillion in early 2022, and is now down to a little more than $7 trillion.

That drawdown was happening at a slow but steady rate of $75 billion per month until earlier this year, when it slowed that drawdown to $25 billion per month.

While the Fed cut interest rates today, which screams stimulus, it also announced that it is continuing that slow $25 billion balance sheet drawdown. This sends a more moderate message.

Today's actions alone are not earth-shattering news, but they do mark a turning point. Rather than try to stimulate a healthy economy, the Fed should focus solely on inflation. There are other, better ways to spark growth and create jobs. Monetary policy is a poor tool for stimulus compared to the real experts: entrepreneurs.