The Fed Prepares for Rate Cuts. But Why?
Jerome Powell all but declared "Mission Accomplished" on the soft landing and made the case for why nominal borrowing costs should fall sharply in 2024-2025. That may be premature.
Federal Reserve boss Jerome Powell has more or less admitted that short-term interest rates have peaked—and that he and his colleagues were already discussing how fast to lower them at their most recent meeting.
While this may end up being the right choice, the reasons being given are not consistent with the arguments that Fed officials have made over the past two years in favor of raising rates. In fact, it seems at least as likely that the Fed should want to keep short-term rates close to (or even above) current levels to keep the economy growing at an even keel. After all, the only thing that has changed significantly over the past few months is that interest rates have come down sharply while risk asset prices have jumped.
The key points:
The news on inflation has been positive, but so far that only reflects what I and others had expected would happen in 2021-2022 once the pandemic- and war-related disruptions to production, distribution networks, and consumption patterns faded. Looking ahead, what matters for inflation is what we are left with once that impulse fades—and there are reasons to think that the underlying trend remains somewhat faster than before the pandemic.
Contrary to what some had expected—and contrary to what some Fed officials seem to believe—measures of economic activity through November continue to rise rapidly even if October looked a little soft. There is little indication that the strong underlying growth rate in the first 9 months of 2023 is decelerating, which has implications for the appropriate level of interest rates.
At the same time, financial conditions have loosened considerably. Stocks, real interest rates, credit spreads, and bank lending flows all have moved in the opposite direction of what one would have expected if monetary policy were actually “restrictive”.
The Disinflationary Assist from Supply-Side Normalization Is Almost Over
Most of the excessive price increases in 2021H2-2022H1 were attributable to the disruptions associated with the pandemic and Russia’s most recent invasion of Ukraine. While those price increases were painful for many people, the alternatives would have been far worse. That inflation should be understood as the price of avoiding mass bankruptcies and destitution in a time of extremes.
Those of us who understood what was happening in those terms therefore expected that the eventual normalization of distribution networks, business operations, and consumption patterns would correspond to a sharp slowdown in inflation. While some prices might fall outright, others would simply stop rising faster than they had before the pandemic. The most obvious analogies were not to the 1970s, but to the temporary wartime inflations of the 1940s and early 1950s.
Normalization took longer than optimists in 2021 had expected, in part due to Putin’s warmaking. But the disinflation that was promised finally arrived in the second half of 2022, and has continued more or less uninterrupted through this month. That is why inflation according to the Consumer Price Index (CPI) has slowed from 11% annualized from February-June 2022 to just 2% in August-November 2023. From this perspective, the Fed has succeeded in returning to target—and at no cost to employment—although it is far from obvious what the Fed actually contributed to this disinflation.
The question is whether the current inflation readings are consistent with underlying economic and financial pressures. If recent price increases are being suppressed in part by temporary idiosyncratic factors, which could disappear or even reverse in the near future, then it would be premature for policymakers to assume that inflation is set to stay stuck at 2% a year.
Yet that is precisely what seems to be happening.