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The writer is a former Federal Reserve economist, founder of Sahm Consulting and a writer of the Stay-at-Home Macro blog
Consumer prices in the US rose more than expected in January, largely owing to shelter costs. And while the Federal Reserve’s preferred inflation metric should be more benign, this was a reminder that the path back to low inflation remains a bumpy one.
But creating bigger bumps in the rest of the economy and financial markets would be a mistake that the Fed must avoid this year.
The good news is that inflation has cooled over the past several months and is moving rapidly towards the Fed’s 2 per cent target, the last month notwithstanding. So, the question is when and how much the Fed will cut its policy interest rate.
As is often the case, the central bank has been intentionally vague. In an interview, Fed chair Jay Powell said his team needed to see “more good data . . . It doesn’t need to be better than what we’ve seen, or even as good.” But how good is good enough? Powell implied that May was the earliest that the Fed would even consider a rate cut. We can expect them to want several more months of good inflation data, then, on top of several months of good inflation data. Clearly, the bar is high.
The Fed is weighing rate cuts against the backdrop of a strong economy. Inflation-adjusted gross domestic product rose 3 per cent in the fourth quarter of 2023 relative to a year earlier, far above the Fed’s forecast this time last year of basically no growth. The unemployment rate has been below 4 per cent for the longest stretch since the 1960s. And all with substantial disinflation.
Some think this strong growth means the Fed should not cut. But that argument relies on the dubious Phillips curve that says to get inflation down, unemployment must rise. The economy in 2023 showed that was wrong; instead, high inflation was largely due to Covid-related disruptions that are unwinding. Plus, 2019 had similar growth and unemployment along with less than 2 per cent inflation. Finally, the Fed has a dual mandate of low inflation and low unemployment. Keeping rates high until the labour market cracks is not acceptable.
At the end of last year, the Fed disavowed the need for below-trend growth to get inflation down. Now, the central bank views that strength as giving it the “luxury of time” to build confidence in inflation. The logic is different, but it risks a recession, which is what pro-Phillips curve commentators think we need.
The risks are real. The federal funds rate is up 5.25 percentage points within two years, and that has put pressure on the housing market. In fact, the Fed is pushing up home prices, because the people who have low, fixed-rate mortgages are unwilling to sell. So new homebuyers are grappling with higher mortgage rates, high home prices and a lack of homes to buy. So far, the rest of the economy has been able to keep the weakness in housing from spreading, but that is not guaranteed to continue.
Another risk is financial markets. The Fed’s rapid, large and unexpected rate rises since 2022 have strained credit markets and banks. So far, borrowers and lenders have navigated them. But, as the dramatic failure of Silicon Valley Bank shows, this environment punishes bad or even unlucky business decisions. It’s hard to say where the pockets of weakness are now, but the longer rates stay high, the more the Fed risks seriously damaging the economy.
Several officials have said the “worst possible outcome” would be for the Fed to start cutting and then have to raise rates if inflation picks back up. It’s an odd, albeit unsurprising, worry, since the Fed has a history of “policy adjustments”. The world changes and so does policy. But the world has changed with notable disinflation, and the Fed is not changing its policy.
From its start, this cycle has had little to do with the Fed. We are so close to unwinding the final Covid disruptions. Now it is not the time for the central bank to drag its feet on rate cuts. It is the time for the Fed to get out of the way.
Source: Economy - ft.com
