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Why the Federal Reserve is ready for its first reduction since the crisis



The Federal Reserve on Wednesday is expected to cut interest rates for the first time in more than a decade, even as economic expansion in the United States reaches record levels, unemployment fluctuates at historically low levels and consumers continue to spend.

Uncertainties about global growth and persistently low inflation are behind the expected move, as both pose major threats to the health of the economy at a time when the central bank has limited ammunition to overcome the downturn. This will be called "insurance reduction" ̵

1; what central bankers do to keep them growing.

Inflation – a key indicator – was too slow.


Inflation




+ 1.6%

Core PCE

(excluding food

and energy)

2008-9 global

financial crisis

+ 1.6%

Core PCE

(without food

and energy)

2008-9 global

financial crisis

+ 1.6%

Core PCE

(without food

and energy)

2008-9 Global

Financial Crisis


Annual Change in the Consumer Price Index (PCE) | Source: Bureau of Economic Analysis

The Fed's main jobs are to maintain maximum employment and stable inflation. Officials have long been aiming for 2 percent as a sweet spot for raising prices. Low inflation is good because it provides a buffer to prevent prices from sinking during slow growth. Ultimate deflation is dangerous because it causes consumers to accumulate money, knowing that goods and services will be cheaper tomorrow.

The problem? Inflation has not reached the sustainable target since the Fed formally adopted it in 2012.

Persistently low inflation also raised the risk that future inflation expectations would decline.


Inflationary expectations





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

This could create a self-fulfilling prophecy, as businesses expecting low inflation can set their prices accordingly.

Although slow price rises may sound great, they can make it difficult for employers to raise wages. Beyond that, the Fed's interest rate policy includes price hikes, so weak inflation leaves the Fed with less room to cut interest rates if the economy goes down.

Policy makers want to pre-empt global economic slowdown.

Concerns have been raised about the trajectory of the world economy. The trade war, the slowdown in China and the weakening of many advanced economies can all add to the growing anxiety.


Global Economic Policy Uncertainty Index





September. 11, 2001

terrorist attacks

2008-9 global

financial crisis

crises in the euro area,

USA. debt-ceiling crisis,

China transition into leadership

European

immigration

crisis

Trump elected

USA. President

Political turmoil in Brazil,

France and South Korea;

USA. trade wars

Political turmoil in Brazil,

France and South Korea;

USA. trade wars

Trump chose

the United States. President

of the euro area crisis,

USA. debt-ceiling crisis,

leadership transition in China

2008-9 global

financial crisis

September. 11, 2001

terrorist attacks

European

immigration

crisis

Political turmoil in Brazil,

France and South Korea;

USA. trade wars

Trump chose

the United States. President of the

Crisis in the Euro Area,

USA. debt-ceiling crisis,

leadership transition in China

global 2008-9

financial crisis

September. 11, 2001

terrorist attacks

European

immigration

crisis

sept. 11, 2001

terrorist attacks

2008-9 global

financial crisis

crises in the euro area,

USA. debt-ceiling crisis,

China transition into leadership

European

immigration

crisis

Trump elected

USA. President

Political turmoil in Brazil,

France and South Korea;

USA. trade wars


Weighted average of national indexes of the frequency of newspaper articles in each country discussing economic policy uncertainty. | Source: Scott Baker (Northwestern University), Nick Bloom (Stanford University) and Stephen Davis (University of Chicago)

At a time when inflation is already low and interest rates don't have much room to fall, politicians want to outpace everyone, all of whom are tomorrow could disrupt American growth.

Manufacturing is one area where growing fears could translate into real economic activity. Indices that track production in many advanced economies are either slowing or decreasing. While services occupy a growing share of G.D.P., the factory's progress is a good economic warning: It slows down earlier than other industries as activity weakens. Fed officials are watching the sector closely.


Purchase of Managerial Indices





Production measure including output, orders, stocks and other factors. * Data until July, all others until June. | Source: IHS Markit, via FactSet

Unemployment is often low until recession, so it's a poor guide for Fed politicians.

While inflation, global uncertainty and hints of slowing economic activity have pushed the Fed to the brink of decline, there are good reasons for not yet predicting a full cycle of rate cuts that returns policy near -zero. Consumers are still spending, the labor market is growing and production is still strong.

But all these data correspond to the economic slowdown with delay.


Unemployment





(Includes unemployed and

people interested in work,

but not actively applying *)

(Includes unemployed and

people interested in work, [19659105] but do not actively apply *)

(Includes unemployed and

people who are interested in work,

but do not actively apply *)

(Includes unemployed and

people who are interested from work,

but not actively applying *)


* Total unemployed, plus all persons who are marginally attached to the workforce, plus the total here is part-time for economic reasons, as a percentage of the civilian workforce, plus all persons marginally attached to the workforce. | Source: Bureau of Labor Statistics

The unemployment rate did not become decisively higher until just before, and sometimes several months after the onset of the recession. As a result, central bankers seem to think this is the time to move – waiting and watching may come later, after the economy has some added juice to come back.


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