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As inflation gained steam in 2021 and 2022, the Federal Reserve notoriously waited too long to raise interest rates, allowing consumer prices to continue rising sharply, Fed officials now acknowledge.
Now that inflation is declining, the Federal Reserve could be about to make another blunder by acting too slowly to cut rates and trigger a recession, some economists contend.
“The longer they wait, the greater the risk that something will go off the rails,” says Mark Zandi, chief economist at Moody’s Analytics.
With annual inflation approaching the Fed’s 2% target and some risks to the economy growing, Zandi says the Fed should start lowering rates in March, or May at the latest. Inflation hovers around 3% or slightly lower, by the two most popular measures, down from a 40-year high of up to 9.1% in June 2022.
But Federal Reserve Chairman Jerome Powell said last month that a cut in March is highly unlikely. And minutes from the Federal Reserve’s late January meeting, released this week, have led some economists to push back their predictions for the first rate cut to June or later.
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Many of them say inflation still poses the biggest threat and that the Federal Reserve is on the right path.
“I think they are right to be patient,” says Barclays economist Marc Giannoni.
What is the current Federal Reserve interest rate?
From March 2022 to July 2023, the Federal Reserve raised its key short-term interest rate from near zero to a 22-year high of 5.25% to 5.5% to help reduce inflation, which is already was slowing as pandemic-related supply chain issues were resolved. . Since then, the central bank has kept the rate stable.
A drop in the benchmark rate would reduce borrowing costs for mortgages, credit cards, automobiles and other consumer and business loans, stimulating the economy. The prospect of lower rates has already driven the stock market to record highs.
But after their two-day meeting last month, Powell told reporters that before cutting the rate, officials want to gain more confidence that inflation “is on a sustainable path to 2%.” According to the minutes, most policymakers were concerned about the risk of moving too quickly to cut rates and reignite inflation. Only “a couple” of officials pointed out the dangers of keeping rates high for too long and causing the economy to weaken significantly or fall into recession.
Is inflation really high right now?
Several reports since the Fed meeting have seemingly vindicated the Fed’s cautious approach. A measure of “core” inflation that excludes volatile food and energy products rose a hefty 0.4% in January, keeping the annual increase at 3.9%, according to the consumer price index.
Is the US economy strong right now?
Meanwhile, last month, U.S. employers added a booming 353,000 jobs and average annual wage growth — which fuels inflation — jumped from 4.3% to 4.5%.
The economy also grew at a solid 3.3% annual rate in the final three months of 2023 and a solid 2.5% for the full year.
The bottom line: Not only is the economy on solid footing, it could cause inflation to rise again as consumers continue to spend their rapidly rising paychecks.
Some forecasters have a different opinion.
Is the rent going down?
It’s true that inflation spiked in January, but that’s just one month and was mostly due to persistent increases in rent and other housing costs, Zandi says. Rent increases are expected to slow in the coming months as falling rates for new leases are passed on to existing leases.
Additionally, a different measure of inflation that the Fed tracks more closely – called the personal consumption expenditures price index – was 2.6% in December and the Fed’s preferred base reading was 2.9%, not far from the 2% target.
And if price increases in the basic personal consumption expenditure price index over the past six months are annualized, inflation is already at 1.9%, Zandi notes.
According to that criterion, “he has achieved his objective,” he says.
Are layoffs increasing?
Meanwhile, he says, the economy is not as strong as it seems. Although employment growth has been vigorous, the hiring rate by employers in November hit the lowest level since 2014, excluding the pandemic recession. In other words, net job gains have been strong because employers have been reluctant to lay off workers in the wake of severe pandemic-related labor shortages (aside from high-profile layoffs from companies like Amazon, Google and Microsoft ).
And although the nation’s gross domestic product grew smartly last year, an alternative measure of economic output that some analysts say is more accurate – gross domestic income – has risen weakly.
Zandi, in turn, maintains that the risk of pushing the economy into a recession is now greater than the chances of boosting inflation.
“You have to be careful not to keep your foot on the brakes (of the economy) for too long,” he says.
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 wrote in a note to clients.
Zandi is especially concerned about an unforeseen banking crisis like the one that brought down Silicon Valley Bank and other regional banks a year ago. High interest rates mean tighter profit margins that discourage banks from lending.
And while companies have so far been reluctant to lay off workers, “that can change quickly,” he says, as high rates increase business costs and reduce sales. Shrinking profit margins could prompt more companies to cut employees to maintain profits, she says.
Economists project economic growth will slow to a still decent 2.1% this year, but see a 36% chance of recession, according to the average estimate of forecasters surveyed by Wolters Kluwer Blue Chip Economic Indicators. This figure is down from the 61% odds in May, but still historically high.
According to a model that takes into account a variety of economic indicators – including GDP, employment and inflation – the Federal Reserve’s key rate should already be at 4% instead of between 5.25% and 5.5%, Zandi says. That would still be well above the Federal Reserve’s estimate of the long-term rate: 2.5%.
Will inflation rise again?
Giannoni, the Barclays economist, agrees that the risks of another price rise in the face of a recession are becoming more balanced. But he believes inflation remains the biggest concern.
“We have been constantly surprised by the strength and resilience of the economy,” he says. “There is a risk that will continue and it means that the path to 2% inflation is not guaranteed.”
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While personal consumption expenditure price index inflation has slowed, Giannoni says it could rise again. Prices for services like health care, auto insurance and dining out have continued to rise sharply, in part because labor shortages have kept average employee pay increases high, he says.
But what about the risk that high interest rates could push the economy into a recession?
“I don’t see the likelihood of that being high,” Giannoni says.