Has the Fed already waited too long to cut rates?

● By holding off on rate cuts, it risks causing unnecessary harm to the economy

Most people who keep tabs on the Federal Reserve would say it waited too long to raise interest rates when inflation took off in 2021. Now the US central bank is arguably falling behind the curve again as inflation moderates and policymakers stall on bringing rates back down. The risk in waiting is that high rates may finally start to inflict harm on an economy that’s so far managed to defy widespread expectations for a significant slowdown.

The Fed is in the long-awaited last mile of its campaign against the bout of pandemic-induced inflation that saw policymakers’ preferred gauge accelerate from 1.8% in February 2021 to a four-decade high of 5.6% in February 2022. Bloomberg Economics estimates data out later this month will show it had returned to 2.8% as of February 2024. That would put it more than three-quarters of the way back to the central bank’s 2% target from the peak two years ago. Yet at their meeting on March 19-20, Fed officials unanimously elected to hold the benchmark federal funds rate in a range of 5.25 to 5.5%, where it’s been since last summer.

Why the delay? One reason is that monthly inflation reports for January and February showed a slower pace of moderation than in the previous six months. But the latest data don’t entirely explain the reluctance to cut. After all, Fed Chair Jerome Powell made it clear at the end of January—before those

Group Inc. (In December, Mericle was among those who anticipated rate cuts commencing in March, but he’s since pushed out his projection to June.)

Perhaps the easiest way to illustrate the Fed’s foot-dragging on rate cuts—and its delayed rate hikes, for that matter—is with the Taylor rule, a standard textbook equation that calculates an appropriate interest rate based on where the inflation and unemployment rates are.

The rule prescribed rate hikes in early 2021, when inflation began accelerating, but the Fed waited a full year to begin tightening. It finally caught up to the rule’s suggested rate level with its last hike, in July 2023. Since then the rule has indicated the rate should move down to 4%—because price pressures

have eased and the job market has softened—but the central bank has yet to budge.

In 2021, Fed officials had undertaken an historic shift in the way they defined their employment goal: It would be conceptualized as “broad-based and inclusive.” The announcement happened to come three months after the police killing of George Floyd. In practice this meant that policymakers would be putting a bit more weight on employment and a bit less on inflation when making interest-rate decisions in a bid to draw more people who’ve historically been near the bottom of the job ladder into the labor market. The shift made sense at the time, especially as the burst of inflation was likely to be “transitory,” as they deemed it then.

Three years later, the backdrop is different. The central bank’s obvious emphasis has been on controlling inflation, even at the expense of employment. Although the jobless rate is still relatively low despite all the rate hikes—that’s been, if anything, a pleasant surprise—Fed officials for a while in 2022 and 2023 were projecting a significant rise in unemployment as a result of their actions.

“We know that the Fed’s weight is heavily tilted toward its inflation mandate versus full employment,” Ryan Sweet, the chief US economist at Oxford Economics, wrote in a March 15 report examining the Taylor rule’s prescriptions. But he found even tweaking the equation to ignore employment and instead emphasize only inflation still puts policymakers behind the curve now when it comes to rate cuts. “Taylor rules have their limitations, and the Fed uses discretion in setting monetary policy, but the Fed is risking waiting too long to cut to ensure that it has limited inflation,” Sweet wrote.

There is another possibility, which is that the central bank could revise up its estimate of the “neutral rate.” That would cause the rule to prescribe higher interest rates for the same level of inflation and unemployment. Some analysts including Mericle expect that to happen at some point given the economy’s resilience to higher rates over the past year, though so far Fed officials have taken an agnostic approach to the question: They’ve left their estimate of neutral more or less unchanged since 2019.

Powell and the FOMC are aware of the fine line they’re walking. They’ve said they want to get going with rate cuts well before inflation returns to 2%, because if they don’t, they’ll probably have waited too long. The economy is looking robust at the moment, but questions remain about whether the pain from higher rates has merely been delayed rather than avoided. There are worrying signs in places such as the commercial real estate and consumer debt markets that may or may not be harbingers of problems that could eventually spill into the wider economy. “The risks are really twosided here,” Powell said on March 20. “If we ease too much or too soon, we could see inflation come back. And if we ease too late, we could see unnecessary harm to employment.”

Before the February inflation reports, it was looking as if policymakers might be running out of time: Some forecasters had thought inflation could return to 2% as soon as May or June. But the latest data have given them some more breathing room. At this point, inflation should “fall to 2.5% or below by June,” meeting Powell’s “well before” criterion for rate cuts, says Anna Wong, the chief US economist at Bloomberg Economics.

February’s uptick in the unemployment rate, to 3.9%, also helps undercut the rationale for keeping interest rates elevated, given that Fed officials view 4.1% as an appropriate level for it in the long run.

Mericle at Goldman Sachs is optimistic about the economic outlook, predicting another year of above-average growth in 2024. Even so, he says, the odds of more easing than currently envisioned are a bit higher than the odds of less easing given “a variety of circumstances that could potentially lead them to cut faster,” such as a financial shock or a growth scare.

“We think that inflation will step back down to something like the softer trend we were running at before January, and if that’s right, then I think there will still be a sense of ‘Why is the funds rate at a level that we only went to because inflation was a few percentage points higher, now that it’s come down?’ ” Mericle says. Matthew Boesler

THE BOTTOM LINE According to a textbook model for setting interest rates known as the Taylor rule, the Fed should have started easing monetary policy several months ago.