Fed officials now acknowledge that the Fed notoriously delayed raising interest rates too long as inflation picked up momentum in 2021 and 2022, causing consumer prices to continue to soar.
Now that inflation is easing, some economists say the Fed may be about to make another mistake by cutting rates too slowly and triggering a recession.
“The longer you wait, the higher the risk that something will go off track,” said Mark Zandi, chief economist at Moody’s Analytics.
Zandi said the Fed should start cutting interest rates in March or May at the latest, as annual inflation approaches the Fed’s 2% target and some risks to the economy are rising. . Based on the two most common indicators, inflation is hovering around 3% or slightly below, declining from a 40-year high of up to 9.1% in June 2022. There is.
But Fed Chairman Jerome Powell said last month that a March rate cut was highly unlikely. Additionally, the Fed’s late January meeting minutes released this week have led some economists to postpone expectations for the first rate cut until June.
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Many say inflation remains the bigger threat and the Fed is on the right track.
“I think they’re right to be patient,” said Mark Giannoni, an economist at Barclays.
What is the current Fed interest rate?
The Fed will raise its key short-term interest rate from near zero to the highest level in 22 years from March 2022 to July 2023 to help curb inflation, which was already slowing as pandemic-related supply chain disruptions resolve. The rate was raised to 5.25% to 5.5%. . Since then, the central bank has kept interest rates unchanged.
Lower interest rates would stimulate the economy by lowering borrowing costs for mortgages, credit cards, autos, and other consumer and business loans. The stock market has already hit record highs on the prospect of lower interest rates.
But Powell told reporters after a two-day meeting last month that officials were becoming more confident that inflation was “on a sustainable downward trajectory to 2%” before cutting interest rates. He said he was thinking of doing so. Most policymakers were concerned about the risk of reigniting inflation by cutting interest rates too quickly, minutes showed. Only “several” officials raised the risk of keeping interest rates high for too long, severely weakening the economy or pushing it into recession.
Is the current inflation rate really high?
Some reports after the Fed meeting seem to justify the Fed’s cautious approach. The Consumer Price Index showed a “core” inflation measure that removed volatile food and energy items led to a sharp 0.4% rise in January, bringing the annual rate of increase to 3.9%.
Is the American economy doing well now?
Meanwhile, U.S. employers surged by 353,000 jobs last month, and average annual wage growth, which contributes to inflation, jumped from 4.3% to 4.5%.
The economy also grew at a solid annual rate of 3.3% in the last three months of 2023, and at a solid annual rate of 2.5% for the entire year.
Bottom line: Not only is the economy on solid footing, but inflation could rise again as consumers continue to spend on rapidly rising salaries.
Some forecasters have a different opinion.
Is the rent going down?
Indeed, inflation flared up in January, but only for a month, and that was largely due to sustained increases in rent and other housing costs, Zandi said. Rent increases are expected to ease in the coming months as the drop in new lease rates trickles down to existing leases.
Also, another measure of inflation that the Fed monitors more closely (called the Personal Consumption Expenditures Price Index) was 2.6% in December, and the Fed’s recommended core value is 2.9%, not far from its 2% target. .
Zandi also pointed out that the annualized rate of increase in the core personal consumption expenditure price index over the past six months shows that inflation has already reached 1.9%.
With that gauge, he says, “you’ve achieved your goal.”
Are layoffs increasing?
Meanwhile, he says the economy is not as strong as it appears. Although job growth is strong, the employer hiring rate in November was the lowest since 2014, excluding the pandemic recession. In other words, (apart from high-profile layoffs by companies like Amazon, Google, and Microsoft), net Employment growth was strong.
And while gross domestic product grew steadily last year, gross domestic income, a proxy measure of economic output that some analysts argue is more accurate, rose only marginally.
Meanwhile, Zandi argues that the risk of pushing the economy into recession is now greater than the chance of pushing up inflation.
“We need to be careful not to keep the brakes on (the economy) for too long,” he said.
Ryan Sweet, chief U.S. economist at Oxford Economics, agrees.
“If the central bank waits for clear signs that the labor market or the broader economy is deteriorating, it will be left behind,” he said in a note to clients.
Mr. Zandi is especially concerned about unexpected banking crises, like the one that caused Silicon Valley Bank and other regional banks to fail a year ago. High interest rates narrow profit margins and prevent banks from lending.
And while companies have traditionally been reluctant to lay off employees, “that could change quickly” as high interest rates reduce sales and raise business costs, he said. . Shrinking profit margins could lead more companies to cut employees to maintain profitability, he said.
Economists still expect economic growth to slow to a modest 2.1% this year, according to the average estimate of forecasters surveyed by Wolters Kluwer Blue Chip Economic Indicators, but the economy remains weak. We see a 36% chance of a recession. That’s down from 61% odds in May, but still historically high.
Zandi says the Fed’s key interest rate should already be 4% instead of 5.25% to 5.5%, according to a model that takes into account various economic indicators such as GDP, employment and inflation. This would still be significantly higher than the Fed’s long-term interest rate forecast of 2.5%.
Will inflation rise again?
Giannoni, the Barclays economist, agrees that the risks of further price increases and recession are becoming more balanced. But he still thinks inflation is a bigger concern.
“We have always been amazed by the strength and resilience of our economy,” he says. “Risks will continue, which means the path to 2% inflation is not guaranteed.”
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Giannoni said that although personal consumption expenditure price index inflation has fallen, it could heat up again. Prices for services such as medical care, car insurance and dining out continue to rise rapidly, in part because labor shortages have kept average wage increases for workers high, he said.
But what about the risk that high interest rates could send the economy into a downturn?
“I don’t think that’s likely,” Giannoni said.
