Federal Reserve in high-wire act over cutting US interest rates
Two years after aggressively raising US interest rates, the Federal Reserve is now in a delicate balancing act as it aims to further steer inflation back to their long-term 2 per cent goal.
With rates likely at their peak target range and PCE inflation battened down to 2.4 per cent, the Fed is setting the stage for the next phase in their fight: cutting interest rates.
Fed officials have cautioned against declaring victory too soon even as a soft landing appears into view.
And although though the central bank still projects it will cut rates three times this year, it suggested recent bumpy inflation data warrants a careful approach moving forward.
“I don’t think we really know whether this is a bump on the road or something more. We’ll have to find out, Fed chairman Jerome Powell said last week.
“In the meantime, the economy strong, the labour market is strong, inflation has come way down, and that gives us the ability to approach this question carefully.”
That uncertainty is central to the Fed’s coming decisions on interest rates. Soon it will have to answer when it will begin loosening its policy, and getting it wrong on either side will have spillover effects in the US and around the globe.
“Part of the problem here is that they won’t know that they’ve overdone it until it’s too late, because by then, because they’ll only know it when the economy slows down and unemployment starts to rise. So, the maths is a bit of a lag,” said Joseph Francois, senior fellow at the Peterson Institute for International Economics and a former senior economist at the Federal Reserve Board.
“By the time they realise that they have overdone it, they’re going to be in a rush to cut rates and they may be too late.”
And their moves will be closely watched by central banks in Europe, the UK and the Gulf who are preparing rate cuts.
The Bank of England and European Central Bank could begin dialling back in June, which is when markets anticipate the Fed will issue its first rate cut.
“People seem to take a cue from the US, and when US interest rates rise other countries rates rise, and we can debate about why that is, but it seems to be true,” Mr Gagnon said. “That will be bad news for other countries in the sense that they’ll see higher rates.
“It’ll push the dollar up or push their currencies down, which maybe they don’t want because that’s bad for their inflation. It sort of de-syncs the whole world.”
Going too early, however, runs the risk of seeing inflation reaccelerate. This would likely force the Fed to raise interest rates once more.
Again, this would spillover across the world with other central banks forced to react to the Fed’s decisions.
“When the Fed tightens, lending tends to flow to the US. And when money flows to the US, other central banks are forced to either raise interest rates or let their currencies depreciate,” said John Leahy, a professor at the Ford School and the Department of Economics at University of Michigan and former Fed visiting scholar.
Peter Andersen, founder of Andersen Capital Management, does not believe the Fed is in a position where it needs to cut interest rates this year.
“I consider the current rates as the most normal rate I have seen in many years, and also symbolic of a normally functioning economy, not an economy that’s on crutches with low rates, not an economy that’s crushed with super high rates, but if anything, slightly low to average,” Mr Andersen. While he commended the Fed for its progress against inflation with so much “soft data”, Mr Andersen argued dialling back this year would undo all the work the Fed has made after bringing the economy to a margin of safety.
“The margin of safety will shrink tremendously,” he said.
Even still, the Fed remains in a delicate position. Because as inflation has been steadily climbing down, the US unemployment rate has slowly been creeping up to its current level of 3.9 per cent.
Raising interest rates are meant to cool the economy in times of high inflation, but it also runs the risk of slowing the economy too much that can eventually result in a recession or high unemployment.
“If the Fed doesn’t loosen, and the economy goes into recession, that’s a completely different situation. If the US economy goes into recession, the spill overs are basically that when the US economy goes into recession, generally Europe goes into recession. The world doesn’t do well,” Mr Leahy said.
Mr Leahy also believes this current Federal Reserve is distinct from previous administrations for taking more consideration of unemployment in its policy decisions.
Adding to uncertainty is the novelty of this inflationary period. Unlike previous cycles, much of the pressure was caused by supply chain issues related to the pandemic.
Also surprising is the resiliency of the economy in the face of the Fed’s interest rates. Instead of falling into a recession, the US economy grew at a 3.2 per cent annualised pace last year.
“The difficulty the Fed is facing is that it’s been hit with this series of fairly unique events. And it’s managed remarkably well,” Mr Leahy said.
“The fact that we’re even having this conversation is probably a good thing for them.”
Part of the problem here is that the Fed won’t know that they’ve overdone it until … the economy slows down JOSEPH FRANCOIS
Former senior Fed economist