2024-03-01 20:37:00
The Fed’s success in bringing inflation down from a multi-year high to within touching distance of the 2% target is an extraordinary achievement, considering the labor market and the state of the broader economy after five percentage point interest rate hikes. Now the main concern is an economy that could overheat.
The Fed is taking a new approach when it comes to risk management in monetary policy. The central bank is considering the potential consequences of lowering interest rates too early versus lowering them too late. Since the Fed began raising interest rates in 2022, its policymakers have often discussed this question in terms of a hard or soft landing, whether or not reducing inflation will trigger a recession, but the Fed may need to consider the additional risk of no landing.
Today’s strong job market shows signs similar to those that appeared almost 60 years ago. If we compare the situation today with the situation in 1967, if the Fed does not want to raise the interest rate in 2025, it is possible that it will choose to forego lowering the interest rate in 2024.
Following initial signs of economic cooling, the Fed began a series of interest rate cuts in late 1966. The central bank continued to cut interest rates in 1967, even though unemployment rates were below 4% and job vacancies were roughly double the number of workers available in the market. Still, with the unemployment rate below 4% and initial signs of economic cooling, the Fed chose to continue lowering interest rates. After nearly three percentage points of declines, a soft landing was achieved, but it was not sustainable. The economy overheated after that causing inflation to rise. By 1969, inflation had already exceeded 6% and the Fed was required to raise interest rates to 9%, twice the level at which interest rates stood in 1967.
Companies remain strong
The unemployment rate remains well below historical averages and job creation figures highlight the resilience of the labor market. And it’s not just the job market. Despite record interest rates, gross domestic product growth continues above trend – that theoretical line between inflationary and non-inflationary. The Fed’s policy is designed to limit financial activity, but the Chicago Fed’s National Index of Financial Conditions has shown a loosening rather than a tightening over the past three months. That is, the profits and balance sheets of the companies remain strong.
Now the question arises, why have the Fed’s interest rate increases to date not substantially softened the labor market and slowed down the economy? The effect may simply be late. However, according to research by Joe Davis from Vanguard, an aging population and growing fiscal deficits have pushed the neutral rate up a percentage point since the global financial crisis, suggesting that policy rates should remain higher than the levels to which we are accustomed. A higher neutral rate helps explain why the economy has so far been able to resist higher interest rates.
The Fed’s preferred index
The personal consumption price index (PCE), which excludes food and energy prices and is considered the Fed’s preferred inflation index, showed an annual increase of 2.4% in January – the lowest annual increase since March 2021, when the index increased by 2.2% compared to March 2020. The core index of the -PCE increased by 0.4% compared to last January and by 0.1% compared to December.
This means that inflation in the US is slowing down, when in December the index presented an annual increase of 2.6%. These data come at a critical time, and this after the consumer price index in the US surprised in December with an annual increase of 3.4% (compared to 3.1% in November) and the GDP data that indicated On a growth of 3.3% – well above expectations for a growth of 1.7%, data that reduce the chances of the Fed lowering interest rates.
The latest data has created renewed enthusiasm in the markets, with indices breaking records. However, while at the beginning of the year the markets were expecting an interest rate cut as early as March, it now seems that the market is pricing in an interest rate cut only in June. And of course it still depends on the incoming data.
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