The US economic reports have been brilliant. The economy appears to be booming, the labor market appears strong, and inflation appears to be declining.
However, this seemingly conducive combination has left the Federal Reserve inactive. At its policymaking meeting this week, the Federal Reserve decided to do precisely nothing. It held the main policy rate, known as the federal funds rate, steady at about 5.3 percent. where has it been Since August.
in a statement On Wednesday, after the two-day session, the Federal Reserve said it would not cut interest rates “until it has gained greater confidence that inflation is moving sustainably toward 2 percent.” And during a news conference, Jerome H. Powell, chairman of the Federal Reserve, emphasized that the Reserve was proceeding cautiously and still waiting for “a real signal” that it was time to act.
But with inflation slowing, markets want much more.
The stock market is eager for an interest rate cut. In previous cycles, when the Federal Reserve began cutting interest rates, risk seekers often saw it as an invitation to start having fun. The S&P 500 hit a record high in January, but stocks have not risen as sharply as they likely would have if a rate-easing cycle were already underway.
The S&P 500 fell 1.6 percent on Wednesday, with the decline fueled by Powell’s comments during the press conference after he said, “I don’t think it’s likely” that the Federal Reserve will cut rates in March.
Expectations of rate cuts have waxed and waned in recent months. Following the Federal Reserve’s previous meeting in December, in which it signaled that rate cuts were likely sometime in 2024, the futures market We began to expect that the start of these rate cuts would occur at the next Federal Reserve meeting, in March.
Late on Wednesday, after Powell’s comments, the probability of a rate cut in March, as expressed by the futures market, had fallen below 40 percent. By the Federal Reserve’s May meeting, the probability of a quarter-point rate cut was around 60 percent, but even that market outlook could prove optimistic.
Similarly, bond yields (which are set by the market and not the Federal Reserve) have risen since December. Recall that yields soared last summer and fall, when the Federal Reserve seemed committed to keeping short-term rates “higher for longer” to combat inflation, while the economy remained surprisingly robust. Since bond yields and prices move in opposite directions, this rise in yields punished bond investors. Now, the last thing the bond market wants is higher yields, but despite a small drop in late January, yields have risen so far this year.
In 1977, Congress educated to the Federal Reserve to “effectively promote the objectives of maximum employment, stable prices, and moderate long-term interest rates.” Three objectives are listed here, but it is assumed that “moderate long-term interest rates” are the natural consequence of an economy that has maximum employment and stable prices. That is why it is often said that the Federal Reserve has a “dual mandate.”
At the moment, the two parts of that mandate are in tension, if not outright conflict.
First, there are stable prices and their nemesis, rampant inflation. The inflation rate has gone down below 3 percent in recent readings, but it is still above the Fed’s 2 percent target, and Powell does not want to risk a spike in inflation that could occur if the Fed cuts rates prematurely. Something similar happened in the 1980s, when Paul A. Volcker was chairman of the Federal Reserve and had to control double-digit inflation. He cut interest rates too soon and had to raise them again, throwing the economy into two recessions.
Powell says he wants to be worthy of Volcker’s example. Keeping control of interest rates until inflation is truly contained is Powell’s stated priority.
Then there is maximum employment. The unemployment rate, which will be updated on Friday, has been below 4 percent for two years. The United States has been closer to peak employment than it has been in decades. At some point, when interest rates rise enough, the economy is expected to slow down and people are expected to lose jobs en masse. That hasn’t happened yet: no recession has materialized.
But Powell has also said he expects the Federal Reserve to begin cutting rates well before inflation falls to 2 percent. At a press conference in December, explained“I mean, the reason they wouldn’t wait until they hit 2 percent to cut rates is because the policy would be too late.” Wait too long and the Fed would “overdo it,” she said, because “it takes a while for policy to enter the economy, affect economic activity, and affect inflation.”
In other words, the Fed’s battle against inflation would conflict with its effort to keep employment high. He could throw the country into an unnecessary recession.
Art, not science
Economics claims to be a science. But economic policymaking is an art that requires delicate timing and astute political judgment.
As the Federal Reserve approaches a turn in this policy cycle—from tightening financial conditions to, at some point, easing them—the real-world implications are manifold. This is, in every sense, a high-risk game.
It is important for everyone who has a job, everyone who buys goods and services, everyone who has a savings account or money market fund, everyone who wants to buy a house, or has investments in the stock markets and bonds or, actually, in just about each market.
The chances of a recession in the United States and the global economy have diminished, the International Monetary Fund said in its latest estimate. But risks remain. Energy prices could easily rise significantly in response to the conflict in the Middle East. Consumer spending, which has boosted the economy, could begin to decline. Interest rates could really start to bite, dislocating vulnerable sectors of the economy.
Yet so far in this economic cycle, the Federal Reserve has had wonderful success, preserving jobs while moderating inflation. And at this point, since the start of Fed tightening in early 2022, most investors are complete: they have largely recovered from the large losses of 2022.
This benign climate has insulated the Federal Reserve from political pressure, although its actions will influence this year’s national elections. At the moment, the economic effects on the political landscape are too rough, although the combination of low inflation and robust growth in recent months has contributed modestly to improved prospects for Democrats, according to a long-standing model operated by Ray Fair, the Yale economist.
As I’ve noted, the Federal Reserve is likely to come under fire if it waits too long to lower interest rates. He could be considered intervening in politics if he acted close to the November elections. Starting a rate-cutting cycle in, say, June, as markets now expect, should provide ample room to preserve the Fed’s appearance of political independence.
Adding this all up, I expect interest rate cuts to begin sometime in the first half of 2024, although how soon within that window is anyone’s guess.
The Federal Reserve is in a difficult position. The timing of its rate change is delicate. It’s hard to be patient when everyone is urging you to act.