The Federal Reserve's latest tweak to monetary policy — a quarter-point cut in its benchmark interest rate plus a strong signal there'll be no more unless there's a major change in economic conditions — was much as investors expected. Reaction in financial markets on Wednesday was muted. It would be wrong to conclude from this calm, however, that all is well with U.S. monetary policy.
Two main issues remain unresolved: the Fed's approach to communicating its intentions, and the depletion of its policy tools should the need for further strong stimulus arise. The next recession is only a matter of time. When it happens, the Fed risks being dangerously ill-prepared.
At the moment, it's hard to say whether the Fed is telling financial markets what interest rates will be or vice versa. Expectations of a small cut with a pause to follow were so firmly entrenched ahead of the central bank's policy meeting this week that any deviation would've come as a destabilizing surprise. In practical terms, the Fed's policy makers were left with little choice but to do as they did.
The clarity of the Fed's communications can't be given much credit for this alignment of expectations and policy. During the course of the now-completed "mid-cycle adjustment" (three quarter-point cuts over the past four months) its guidance has fluctuated between two principles. One is "wait and see," or let the data decide; the other is to take out "insurance" against mounting risks.
President Donald Trump's reckless trade policy has indeed added to the risks of a U.S. and global slump. But in dealing with that problem, monetary policy is largely beside the point. Moreover, the Fed's two guiding principles happen to be contradictory: Insurance is something you buy when you aren't willing to wait and see.
The minute attention paid to trivial changes in the Fed's announcements is telling. The new policy statement dropped the words "will act as appropriate to sustain the expansion" and replaced them with a promise to assess "the appropriate path" for the target interest rate. This signal was pounced on by analysts and deemed clear enough: The expansion no longer needs the sustenance of further rate reductions. In fact, the Fed is promising only to avoid doing anything inappropriate. The hard policy content of such a promise is roughly zero.
Bear in mind that, as things stand, clear communication is about the only tool the Fed will have when the next recession strikes. Interest rates are so low — the new benchmark range is from 1.5% to 1.75% — that they cannot provide the kind of stimulus that recessions typically require (a cut of about five percentage points).
Buying bonds — so-called quantitative easing — is unlikely to be very potent next time around. To make matters worse, the Fed's use of this instrument is complicated at the moment by glitches in the market for very short-term borrowing. A kind of QE — but not true QE, the Fed insists — has been adopted as a fix. The connections between the Fed's balance sheet and liquidity conditions in financial markets, it appears, still aren't well understood.
In effect, the Fed just announced a monetary-policy pause. Let's hope this will continue to be, you know, appropriate. But in any event it should be used for some hard thinking about communication and alternative tools, including possible use of a hybrid fiscal and monetary instrument. Unless something changes, the next recession threatens to leave both the Fed and the economy brutally exposed.
This editorial is the opinion of the Bloomberg Opinion's editorial board.