Why Cut Interest Rates in an Economy This Strong? A Big Question for the Fed.

Why Cut Interest Rates in an Economy This Strong? A Big Question for the Fed.

The Federal Reserve is widely expected to leave interest rates unchanged at the end of its meeting on Wednesday. But investors will be watching closely for clues about when and by how much it might cut those rates this year.

The expected rate cuts raise a big question: Why should central bankers cut borrowing costs when the economy is growing at a surprisingly strong rate?

The United States economy grew 3.1 percent last year, up from less than 1 percent in 2022 and faster than the five-year average before the pandemic. Consumer spending rose faster than expected in December. And even though hiring has slowed, America still has an unemployment rate of just 3.7 percent — a historically low rate.

The data suggests that while interest rates increased to 5.25 to 5.5 percent, the highest level in more than two decades, the increase was not enough to slow the economy. In fact, growth remains faster than the pace many forecasters consider sustainable over the longer term.

Fed officials themselves predicted in December that they would make three rate cuts this year as inflation steadily cooled. But cutting interest rates against such a robust backdrop may require some explanation. Typically, the Fed tries to keep the economy at a balanced level: it lowers interest rates to boost borrowing and spending and speed things up when growth is weak, and raises them to cool growth and ensure that demand does not overheat and drive up inflation.

The economic resilience has raised suspicions among Wall Street investors that central bankers may wait longer to cut interest rates – they had previously bet heavily on a move lower in March, but now see the odds at just 50-50. But some economists said there could be good reasons for the Fed to cut borrowing costs even if the economy continues to weaken.

Here are some tools to help you understand how the Fed is thinking about its next steps.

The central bank will not release new economic forecasts at Wednesday’s meeting, but Fed Chair Jerome H. Powell could provide details about the Fed’s thinking during his post-policy news conference at 2 p.m.

One topic he is likely to discuss is the all-important concept of “real” interest rates – interest rates net of inflation.

Let’s unpack this. The Fed’s key interest rate is stated in what economists call “nominal.” That means when we say interest rates are around 5.3 percent today, that number doesn’t take into account how quickly prices are rising.

However, many experts believe that what really matters to the economy is the level of interest rates after they are adjusted for inflation. Finally, investors and lenders consider the future purchasing power of the interest they earn when making decisions about whether to help a business expand or whether to extend a loan.

When price pressure eases, economically relevant real interest rates rise.

For example, if inflation is 4 percent and interest rates are set at 5.4 percent, real interest rates are 1.4 percent. But if inflation falls to 2 percent and interest rates are set at 5.4 percent, real interest rates will be 3.4 percent.

That could be the key to Fed policy in 2024. Inflation has been slowing for months. This means that interest rates today are exactly where they were in July, but have risen when adjusted for inflation – which is putting more and more strain on the economy.

Increasingly high real interest rates could put pressure on the economy just as it is beginning to show signs of slowing and could even pose the risk of a recession. As the Fed wants to slow the economy just enough to cool inflation without slowing it so much that it triggers a downturn, officials want to avoid overdoing it by simply sitting still.

“Their goal right now is to maintain the soft landing,” said Julia Coronado, founder of MacroPolicy Perspectives. “So why risk tightening policies? Now the challenge is to weigh the risks.”

Another important tool for understanding this moment in Fed policy is what economists call the “neutral” interest rate.

It sounds strange, but the concept is simple: “Neutral” is the interest rate setting that keeps the economy growing at a healthy pace over time. When interest rates are above neutral, they are expected to weigh on growth. If interest rates are below neutral, they are likely to stimulate growth.

This dividing line is difficult to determine in real time, but the Fed uses models based on previous data to set it.

Officials currently assume that the neutral interest rate is around 2.5 percent. The Fed’s key interest rate is around 5.4 percent, which is well above neutral even when adjusted for inflation.

In short, interest rates are so high that officials would expect them to put a serious strain on the economy.

So why isn’t growth slowing more significantly?

It takes time for interest rates to take full effect, and these delays could be part of the answer. And the economy has slowed through some key measures. For example, the number of job vacancies has continuously declined.

However, as consumer spending and overall growth remain strong, Fed officials are likely to remain concerned that interest rates may not weigh on the economy as much as they had expected.

“The last thing they want to do here is declare their mission accomplished,” said Gennadiy Goldberg, head of U.S. interest rate strategy at TD Securities. “I think they’re going to be very careful about how they communicate this – and I think they need to be.”

The question is how the Fed will respond. So far, officials have indicated that they do not want to completely ignore rapid growth and that they want to avoid cutting interest rates too soon.

“Early rate cuts could trigger a surge in demand, which could put upward pressure on prices,” said Raphael Bostic, president of the Federal Reserve Bank of Atlanta, in a Jan. 18 speech.

At the same time, today’s strong growth has come at a time when productivity is improving – companies producing more with fewer workers. This would allow the economy to continue to grow strongly without necessarily driving up inflation.

“The question is: Can this be sustained?” said Blerina Uruci, chief U.S. economist at T. Rowe Price.

Ms. Uruci doesn’t think the strong economy will stop Fed officials from starting rate cuts this spring, but believes it will prompt them to try to keep their options open going forward.

“They have the advantage of not having to commit in advance,” Ms. Uruci said of the Fed. “You have to proceed carefully.”

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2024-01-30 10:02:02