Sunday, July 28, 2019

Explaining The Possible Rate Cut

Powell is shaping up to be one of my favourite Fed Chairmen and if he continues to use market forecasts as a way to determine a stance on monetary policy he will certainly become my favourite one. Recent controversies surrounding the possible rate cut make it clear that people still aren't aware that interest rates aren't a good indicator of the stance on monetary policy, due to confounding variables such as the Fisher Effect and IOER. 

The nominal rate is the rate set by the Fed and is used to influence economic outcomes. The natural rate is set by classic supply and demand forces in the market. Currently, the natural rate is falling rapidly; this means that if the Fed were to keep rate steady, or worse, raise rates, then monetary policy would be highly contractionary, it would be too tight. You cut rates, not to expand, but to avoid tightening. Think of it as the Fed really just keeping their rate the same. If you're thinking that interest rates are indicative of the stance of monetary policy this makes sense, but they're not. The cut is not expansionary, but to keep monetary policy steady. This is a great policy change from the fed and shows they're looking at market forecasts which could have made the recession less bad.

Short Version: Monetary policy would be too tight since the nominal rate, the rate set by the fed, would be way higher than the real rate, the one set by supply and demand forces in the market. This indicates super tight money, which we don't want. The nominal rate is set to influence the real rate to produce desirable outcomes.

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