Fed set to cut rates for first time in decade. Is it a risk?

There’s little dispute that the Federal Reserve this week will do something it hasn’t done since 2008, when the U.S. economy was gripped by the Great Recession: Cut its benchmark interest rate.

This time, by contrast, the economy is solid by most measures. Consumers are spending. Unemployment is close to a half-century low. A recession hardly seems imminent.

Yet the Fed under Chairman Jerome Powell has signaled that rising economic pressures — notably from President Donald Trump’s trade wars and from a global slowdown — have become cause for concern. So has an inflation rate that remains chronically below the Fed’s target level.

So the Fed has decided that a rate cut now — and possibly one or more additional cuts to follow — could help inoculate the economy against a potential downturn. The idea is that lowering its key short-term rate, which can affect consumer and business loans, could encourage borrowing and spending and energize the economy.

Wall Street has welcomed that prospect. Since the start of the year, the mood of investors has swung decisively from angst about potentially higher rates to elation over the prospect of looser credit. That has helped drive a stock market rally.

Still, skeptics wonder whether Fed rate cuts at this point would really do much to bolster an economy whose borrowing rates are already low. Some even worry that the central bank will be taking a needless risk: By cutting rates now, the Fed is disarming itself of some ammunition it would need in case the economy did slide toward a recession. Some also suggest that by driving rates ever lower, the Fed might be helping to fuel dangerous bubbles in stocks or other risky assets.

Powell will surely be asked about these concerns at a news conference Wednesday after the Fed ends its latest meeting with a policy statement. Reporters will likely also press him about the likelihood of further rate cuts to follow this week’s expected move and also whether continued pressure from President Donald Trump to cut rates is damaging the Fed’s political independence.

Trump kept up his drumbeat of criticism, complaining in tweets Monday that the Fed raised rates “way too early and way too much” and a small rate cut now “is not enough.”

Two government reports last week — on economic growth during the April-June quarter and orders for durable manufactured goods — confirmed that the economy remains on firm footing even with pressures at home and abroad. As a result, some analysts the Fed may pause after Wednesday’s rate cut to see if the economic outlook further brightens before deciding on any further easing.

Other analysts foresee two or even three rate cuts this year as the Fed tries to counter global threats that risk spreading to the United States — not just prolonged trade rifts but also a potentially botched exit by Britain from the European Union, a weaker China and the risk of a recession in Europe.

The Fed’s current rate policy marks the continuation of an abrupt policy shift beginning early this year. In December, the Fed had raised its benchmark rate for the fourth time in 2018 and projected two additional rate increases in 2019. At the time, Powell also suggested that the Fed would keep reducing its bond portfolio indefinitely — a step that would further contribute to higher rates. Stock prices tumbled for days afterward.

In January, Powell and the Fed signaled a sudden policy shift — indicating that they would be “patient” about any changes in rates and implying that rate hikes were off the table.

After U.S.-China trade talks collapsed in May, the Fed went further and began considering acting to sustain the economic expansion, which has just become the longest on record.

Yet now, with U.S.-China trade talks back on track and signs of a resilient U.S. economy, some are wondering why the Fed is considering a rate cut. One theory is that the policymakers have so clearly signaled that a cut is coming that they must follow through on it.

Mark Zandi, chief economist at Moody’s Analytics, said he thinks that in the absence of any economic calamity, only one rate cut is likely this year. David Jones, an economist who has written books about the Fed, agrees with that forecast.

“The market is getting ahead of itself in expecting a series of rate cuts,” Jones said.

Diane Swonk, chief economist at Grant Thornton, noted that some concern has arisen that the Fed may already be fueling a bubble in stocks that could eventually burst and threaten the economy.

In the meantime, there’s little incentive to sell stocks. Indeed, “Don’t fight the Fed” is a common saying on Wall Street. To traders, it means riding stocks and other risky investments when the Fed is cutting rates and lightening up on stocks when it’s tightening. Low rates mean that bonds pay out less in interest, which makes stocks more attractive by comparison.

Investors often assess a stock’s price by how much the company earns. So far this year, investors have gone from paying $14.47 for each $1 in expected earnings per share for S&P 500 companies over the ensuing 12 months to more than $17. That increased willingness has helped S&P 500 index funds surge more than 20% this year — even though earnings for S&P 500 companies were likely down in the first six months of 2019 from year-ago levels.

“We have incredibly low rates, and the Fed is going to be very accommodative,” said Craig Hodges, portfolio manager at Hodges Funds. “If anything unforeseen happens, like if tensions escalate worldwide or if the trade talks break down, the Fed is there to have a safety net under us. That gives me a little bit of confidence.”

Of course, how much further the stock market has to go is up for debate. The last 19 times the Fed began a rate-cutting cycle in response to slowing growth, dating to the 1950s, the economy eventually slipped into recession in nearly half of them, according to Deutsche Bank. In those recessions, the S&P 500 typically dropped 27% from peak to trough.

If anything, the market rally may increase pressure on companies. Few analysts see the stock market as cheap now that investors are willing to pay so much more relative to corporate profits. For the stock market to make its next move higher, growth in profits may need to lead the way.