THE FED'S JULY RATE CUT

Many economic units are waiting for the U.S. central bank’s rate cut decision. The Fed is going to announce its decision regarding a new interest rate on Wednesday. The general expectation is that the Fed would reduce the rate by 25 basis-point from 2.50% to 2.25%. However, many of us may not know why a rate cut would be suitable for the U.S. economy. I touch on Fed’s decision making on interest rates in this article. How does the Fed determine target rate to compensate economy, why is adjusting interest rates so crucial, and what is wrong with the U.S. economy now?

Interest rates have been driven up since 2008 and held constant at 2.50% for a while. The Fed implemented a “wait and see” policy during more than half of 2019. Just on the eve of rate cut decision, it is still a bit questionable that the Fed should cut the rate by 25 basis-point. As some economists support this idea, others differ by saying 50 basis-point cut should be performed to act quickly so that a likely recession would refrain. Those who support 25 basis-point rate cut want to be sure if the economy has heated enough which means that growth is above its potential, unemployment is below its natural rate and inflation is higher than it has to be. Hopefully, they all agree on a rate cut anyway because inflation is not above the level 2% which Taylor proposes it as desirable level and the dollar is unnecessarily appreciating in a way that might cause to damage on domestic production and export.

On the other hand, there are further reasons to decrease interest rates, such as shrinking global demand for domestic products, low difference between 3 months short term and 10 years long term treasury bond yields, and reluctant markets tending to decline. It seems like all these circumstances indicate the necessity of a rate cut, therefore it is certain that the Fed will go with that opinion. However, how much rate cut would be appropriate depends on Taylor Rule. I am going to present if the Fed’s rate cut should be moderate or rigid after calculation gives us the closest target rate.

Monetary policy has two main goals: price stability and financial sustainability. If the Fed wants to raise inflation to its target 2%, it needs to impose a reduction on interest rates to stimulate the economy. Nevertheless, quarterly growth and unemployment exceeding expectations seem solid so the Fed may be willing to cut the rate in a modest way without disrupting target inflation. Yet it seems to me that the Fed would cut the rate by more than 25 basis-point, or else economy might roll to recession due to diminishing inflation and economic activity. I discuss why it should be more than 25 basis-point by using Taylor’s formula.

Firstly, I need to remind you of the formula: I=π+r*+απ(π-π*)+αy(y-y*). Then I reform it with numbers I picked before and we find target rate: I=1.7%+0.425%+0.7(1.7%-2%)+0.3(2.8%-2.1%)=2.125

Consequently, result 2.125 shows the Fed should fix the target rate as 2.125% which means the economy would be in balance if a 37.5 basis-point rate cut was taken place. No inflationary pressure overlapping a 2% desirable level would appear. Markets would be satisfied with it. Economic activity would continue recovering. Short term bond yield curve would be turned upside down as it needs to be.

What will navigate the financial markets is going to be subject to explanations of Federal Reserve Board whether its remarks are dovish or hawkish afterward. As we always need to remember: There are no facts in the economy, there are preferences and costs.