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Should the Federal Reserve heed Trump’s call for interest rate cuts?

Despite claiming that the economy is great, the president, vice president and the administration’s economic staff are all clamoring for the Federal Reserve to cut rates sharply. Should the Fed do that?

Federal Reserve Board Chair Jerome Powell speaks at a news conference following a two-day meeting of the Federal Open Market Committee, Wednesday, May 1, 2019, in Washington. (AP Photo/Patrick Semansky)
Federal Reserve Board Chair Jerome Powell speaks at a news conference following a two-day meeting of the Federal Open Market Committee, Wednesday, May 1, 2019, in Washington. (AP Photo/Patrick Semansky)Read morePatrick Semansky / AP

Despite claiming that the economy is great, the president, vice president and the administration’s economic staff are all clamoring for the Federal Reserve to cut rates sharply. Should the Fed do that?

No, and here is why.

First, is economic activity really booming? That depends upon how you define “booming.” Though the economy expanded at a surprisingly solid 3.2 percent pace in the first quarter, that doesn’t mean growth is strong.

The devil — and information — are in the details, not the headline number. And the GDP report’s details were underwhelming.

Households and businesses drive the economy. In the first quarter, consumer spending increased at the second slowest pace in nearly six years. As for business investment, it expanded at a tepid 1.5 percent rate. Those numbers don’t indicate the economy is roaring.

Yes, the pace of growth is strong enough to generate solid job gains. But again, there are some notes of caution. Wage gains have moderated, limiting consumer purchasing power growth.

Simply put, the economy is in good shape: It is not too hot, nor too cold, though maybe not just right, either. More important, the moderate growth is sustainable.

Given this economic environment, what should the Fed do?

Consider, first, a rate cut. Typically, the Fed reduces rates if the economy needs assistance. That is not currently the case. Economic conditions are just fine.

Cutting rates, though, could create significant problems. Interest rate policy is the Fed’s prime tool to deal with economic issues. The rate the Fed controls directly, the fed funds rate, remains extremely low.

For the Fed, that has to be worrisome. Inflation is below its 2 percent target despite tight labor markets. What happens if the economy softens or, even worse, falls into recession and the wage gains disappear?

Given the low inflation, the argument could be made that the Fed should reduce rates to accelerate growth and inflation. Unfortunately, that might hurt more than help.

It is not clear that reducing rates would actually improve growth. Housing is soft but mortgage rates are already quite low. A lack of supply and high home prices in many areas are restraining housing. Lowering rates would not change that.

As for businesses, investment hasn’t surged even after a tax cut that almost paid firms to invest. And corporate borrowing costs are also extremely low.

Consequently, cutting rates is not likely to accelerate growth significantly, if at all. But it would put the Fed in a bind if the economy faltered.

At the current level of rates, there are few arrows in the Fed’s monetary policy quiver. And the lower the level gets, the faster the arrows disappear.

Critically, the impact of rate cuts is not symmetric across all levels of rates. Does anyone really believe that going from 1 percent to zero would do much?

The Fed would consider cutting rates below 1 percent only if the economy were in or nearing a recession. In that period of economic weakness, it would be unlikely that interest-sensitive sectors, such as housing, business investment and vehicles, would experience a measurable rise in demand.

Adding it all up, it makes no sense to cut rates right now.

Well, what about raising rates?

The Fed normally increases rates when it wants to slow growth. But the expansion is hardly getting out of hand and as noted, inflation is below the Fed’s target.

But there is another reason the Fed might consider raising rates: to refill its quiver. The recent rate hikes were not intended to slow growth, which hasn’t been too fast for a decade.

Instead, the Fed is trying to “normalize” the level of rates and position itself so that when the next recession threatens, it has enough room to lower rates and forestall or limit the downturn.

Unfortunately, the Fed has not yet gotten to that level. Economic uncertainties, political pressures, and investor fears prevented it from reaching its desired level. In December, when the Fed showed little inclination to stop hiking, investors threw a temper tantrum. The Fed folded.

So, we shouldn’t lower rates, while raising rates would be a difficult step for the Fed to take. That leaves the monetary authorities with maintaining the current level of rates, which the Fed has pledged to do.

Keeping rates constant seems to be the policy of least resistance. Let’s hope a major slowdown doesn’t occur soon, as the Fed has minimal ammunition to counteract a downturn and with the budget deficit soaring, fiscal policy would be limited, as well.