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2%-2.25%: New interest rate set by the Fed in July
1: Rate decrease by the Fed in the past decade
10: Rate increases by the Fed in the past decade
SBJ photo illustration by Jessica Rosa
2%-2.25%: New interest rate set by the Fed in July

1: Rate decrease by the Fed in the past decade

10: Rate increases by the Fed in the past decade

Making Monetary Policy: Fed cuts interest rates to balance economic growth, inflation

Posted online

At the end of July, the Federal Reserve switched gears on interest rates, dropping its target for the key federal funds rate.

At the end of 2018, the target range for the federal fund rate was its highest since the Great Recession at 2.25%-2.5%. But, on July 31, the rates dropped a quarter percent. This is the first time since 2008 that these rates have been lowered, according to data from the Fed.

Steve Mullins, an economics professor at Drury University, said the move was designed to keep the U.S. economy moving.

“It was a modest cut, but it was a dramatically drastic change in what the Fed has been doing for the previous four years,” he said. “Between December of 2015 and December 2018, the Fed had raised the federal interest rate nine times. It’s a switch in their policy.”

Mullins said the four increases to the interest rate last year were influenced by the Fed’s belief the economy might be growing too fast to keep pace with inflation.

“But now they’ve switched gears and they are loosening up on credit conditions because the economy might need flowing a little bit,” he said.

In announcing the rate drop to 2%-2.25%, the Federal Open Market Committee, a group that sets the Fed’s monetary policy, stated the Fed’s goal of inflation has not yet been met.

“Although growth of household spending has picked up from earlier in the year, growth of business fixed investment has been soft,” the statement reads. “On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2%.”

Even though the U.S. economy continues to grow, according to the statement, the Fed is still hoping to meet its target for inflation rates.

An interview request with officials at the Federal Reserve Bank of St. Louis was not returned by press time.

Mullins said although a quarter-percent drop might not seem like a big change, the Fed probably anticipates the move making enough of a difference to help boost the economy while keeping inflation in check.

“It wasn’t a large cut, but most consumers are involved with credit card debt or mortgage debt or auto loans,” he said. “Anything that lowers market interest rates is going to make it a little less expensive to borrow or to finance those big-ticket items. That’s precisely why they cut the rates. They are trying to encourage a little more spending on the economy to give it a little bit more strength, because there’s evidence that the economy might flake out.”

Mullins said evidence of potential economic instability is based on the trade war with China and other international uncertainties.

A squeeze on banks
Don Davis, vice president and senior portfolio manager at Commerce Trust Co. in Springfield, said although the short-term interest rates have been lowered, it’s more complicated than that for consumer mortgage loans.

“There’s really two things to think about when you look at interest rates – the short rates, which is what the Fed controls; the other side of that is the longer rates,” he said. “The 10-year Treasury note is something that we gauge a lot of things around, but most importantly mortgage rates are based off of the 10-year Treasury.”

Davis said even when the short-term rates were increasing last fall, the 10 year Treasury rate got as high as 3.25%. It’s now down below 1.60%, which along with a similar decline in interest rates abroad, has signaled a global economic slowdown.

“It’s had a two-prong effect,” he said. “It hurt banks by the short rate having come down a little bit, because banks make their spread on loans. It’s started to hurt banks because it’s starting to squeeze their margins.”

Davis said staying ahead of inflation could mean more cuts by the Fed.

“With recent activity in the stock market and as interest rates continue to fall, most likely we are to think that it might get another half of a percent or maybe even three quarters before the end of the year of an additional rate cut,” he said.

Even though in the short term he said the reduced interest rate might seem like a positive thing to consumers, if the Fed reduces the rate again, it could change the state of loaning as U.S. consumers currently know it.

“If they continue cutting short rates, it continues to narrow the margins that banks will make on loans, and if the economy slows, they’ll make even fewer loans,” he said. “You have the prospect of fewer loans and the amount of margin the banks will make on those loans even getting compressed further. It’s kind of a double whammy. You’re seeing banks kind of prepare for a slower lending environment.”

Uncertainty in the economy
Mullins said this cut is aimed to keep the U.S. economy strong, in the wake of uncertainty in the world’s economy.

“They see a sign of weakness in the national and global economy,” Mullins said. “They are basically trying to give the economy a little bit of a boost to keep the 10 year-old, economic recovery on track.”

Mullins cited the trade war with China, the economic conditions of other countries and the fact the Fed hasn’t hit its target with inflation yet, as signs of instability in the current economy.

Data from Commerce Trust show the 10-year government bond yields percentage average 0.35% across the globe, while the U.S. is below 1.6%. According to Davis, the U.S. percentage is much higher than other countries, but the yield curve has started to flatten out. He said the Fed has to stay on top of inflation and keep the economy flowing.

“Putting money to work now is critical,” the trust company report reads. “Over the next few years, we see growth deteriorate to a point where we might have the lowest 10-year U.S. Treasury yield we have ever seen. Europe might be a perfect example of our path.”

Davis said economic stability is what the Fed continues to aim for, and banks also are trying to prepare for any scenario.

“The fear that we’re trying to stay out in front of is, what if the contagion from global economic growth continues to slow and pass to the U.S.?” he said. “The weakness from the Chinese trade war impacts us further, so (the Fed) is trying to stay in front of that and banks are trying to prepare for that, as much as they can.”

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