The Federal Reserve lowered the Federal Funds target interest rate by .25% this past week to 2.25%, marking the first Federal Reserve interest rate decrease in 10 years, and a shift in policy to stimulate the economy. The move was remarkable since it comes at a time when unemployment is at 3.7% and the economy, by most measures, is still growing at a healthy pace.
The Federal Funds Rate is one of the primary policy tools that the Federal Reserve uses. In simple terms lowering interest rates increases borrowing and stimulates the economy, while raising interest rates decreases borrowing and slows the economy. So why wouldn’t the Federal Reserve simply keep interest rates low and let the economy keep growing. There are several factors, but the key reason is inflation.
The Federal Reserve has a dual mandate of “maximum employment” and “stable prices” (meaning low inflation). Traditionally, those two goals have been conflicting, as economic theory teaches us that the lower unemployment declines the more prices will rise. This relationship does make intuitive sense since tight labor markets lead to wage increases which lead to increased wealth which lead to higher prices. Therefore, throughout history the Federal Reserve has been forced to choose, or at least balance, their policy between the goal of low unemployment and low inflation. If the economy slows too much or declines, then unemployment traditionally spikes and lower interest rates are needed to stimulate the economy. Conversely, if the economy gets too hot then inflation traditionally spikes and higher interest rates are needed to slow the economy.
The current economy is unique in its concurrent low unemployment and low inflation. In fact, the historical relationship between low unemployment and inflation seems to be broken. Unemployment is near historical lows, wages are rising, and inflation also remains as a remarkably low 1.6%. It appears, at least for the moment, that inflation is dead. In fact, the Federal Reserve is worried that inflation is ‘too low’ and that deflationary forces in the world will cause prices to decline.
Saying that inflation is dead has significant investment implications. Low inflation is very good for investors and arguably has allowed the current rally to continue for so long. Low inflation means that the Federal Reserve does not have to raise rates to slow the economy and can remain stimulative for a longer period of time. Low inflation helps keep investment prices high, particularly for stocks and bonds, and low inflation keeps prices stable benefiting retirees on a fixed income. Despite what it may feel like at the gas pump, or the grocery store, inflation remains dead, and that is a good thing.