Why the Fed Should Cut Rates Now—Not Wait Until September
The Federal Reserve pushed interest rates above 5% a year ago, determined to achieve two things: much lower inflation and a cooler labor market.
It has succeeded. Inflation, by its preferred gauge, has fallen from 4.3% then to an estimated 2.6% now, the steepest decline since 1984, and within shouting distance of the Fed’s 2% target. Meanwhile, the unemployment rate has risen to 4.1% from 3.6%, an increase seldom seen outside recessions.
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The Fed seems reluctant to take the win. This week Fed Chair Jerome Powell refused to say when, or if, the Fed would cut interest rates, New York Fed President John Williams said he needed more data, and Fed governor Chris Waller merely acknowledged a cut was “getting closer.” Markets expect a cut in September.
The Fed’s reticence is understandable. It likes to telegraph its plans well in advance and, having blown its forecasts on inflation so badly before, is doubly cautious.
But if the Fed were truly data-dependent and trusted its own forecast, it would be comfortable cutting interest rates now. At a minimum, the option should be actively debated at its meeting in two weeks. A cut does bring risks, but so does waiting. Here’s how the Fed should weigh those risks.
Once burned on inflation, twice shy
The Fed’s caution dates back to its infamous prediction in 2021 that inflation would be transitory. Gross domestic product was still well below the prepandemic trend, and unemployment was above its long-run “natural” level. That slack, according to models used by the Fed and private forecasters, meant even a massive fiscal stimulus should not have pushed inflation up much, especially since public expectations of inflation, which tend to be self-fulfilling, were anchored at 2%, roughly where they had been for two decades.
Forecasters missed how the pandemic had scrambled supply chains and work patterns, and driven millions from the labor force. When stimulus-fueled demand ran into those supply constraints, prices leapt. Wages soon followed. As unemployment plunged below 4% and vacancies soared, the Fed feared a wage-price spiral and jacked up interest rates to between 5.25% and 5.5%, where they stand today.
Higher rates cooled demand, but inflation fell mainly because of recovering supply chains and receding fiscal stimulus. The shocks of recent years have left prices and wages much higher, but their impact on ongoing inflation—the rate of increase in prices—has proved mostly transitory.
As a result, interest rates that looked appropriate a year ago now look too high. Economists have devised several simple formulas, such as the “Taylor Rule,” as monetary policy guidelines, and they suggest rates ought to be lower.
The risks of waiting
Overall economic growth has decelerated gently, to around a still-healthy 2%, this year. Unemployment at 4.1% suggests the labor market is neither too hot nor too cold. The stock market is at a record high. This doesn’t look like an economy in need of lower rates.
But there are warning signs. Historically, when unemployment rises this much, it tends to keep going up. True, the increase may reflect a rising supply of labor, likely migrants lacking permanent legal status. Labor demand looks solid, with monthly job growth this year above 200,000, based on the Labor Department’s payroll survey. But its separate household survey shows anemic job growth, leaving the true picture unclear.
High interest rates haven’t slowed growth much because so many homeowners and businesses locked in rates when they were low. But stress is accumulating: credit card and auto loan delinquency rates are now above prepandemic levels.
The risks of cutting
The biggest risk to cutting now is that inflation might not be defeated. Yet a reacceleration looks quite unlikely. With the benefit of hindsight, it looks like the shocks of the past few years triggered a sequence of one-time boosts to prices. For example, semiconductor shortages caused auto production to plunge in 2021 and prices to jump. New-car inflation peaked in early 2022, followed nine months later by repairs and maintenance and, with a two-year lag, car insurance.
These echo effects are one reason inflation’s downward path has been so bumpy, including an unsettling uptick over the winter, and the underlying trend so difficult to discern.
But while such shocks can temporarily raise inflation, they can’t sustain it unless other conditions are in place, most of all a tight labor market. And they no longer are.
Vacancies have fallen from a record two per unemployed worker in early 2022 to a more normal 1.2 now. Unemployment is rising. Annual wage growth has fallen from 5.9% in March, 2022, to 3.9% in June, and is set to fall further next year judging by a survey of companies’ pay plans by WTW, a consulting firm.
While inflation is unlikely to reaccelerate, there is a risk it will stall around its current 2.6% (excluding food and energy) rather than falling to 2%. Indeed, the 12-month inflation rate might tick higher soon as low monthly readings from a year ago drop out of the calculation.
If that happens, though, the Fed can simply not cut again: that’s what being data-dependent means. Rates would still be at a restrictive level.
No-win politics
Officials insist November’s election plays no part in their decision, understandably: No matter what they do, one party will be upset. Republican candidate Donald Trump indicated in an interview with Bloomberg that the Fed shouldn’t cut at all between now and the election. Democrats will similarly lash out if the Fed doesn’t cut.
Still, Goldman Sachs chief economist Jan Hatzius said that to the extent politics factor into the Fed’s thinking, they argue for making the decision as far from the election as possible, i.e., now, not in September.
Right now, odds are the Fed won’t cut in two weeks but will signal it is ready to do so in September. That should keep markets calm. But an actual and an expected cut aren’t the same thing. Economists surveyed by The Wall Street Journal on average put the probability of recession in the coming year at 28%—not high, but higher than normal. If that risk becomes reality, even a few months’ delay will have mattered.
Write to Greg Ip at [email protected]