Fed should not dally much longer in cutting interest rates

The economy is performing well. It is creating lots of jobs, unemployment is low and stable, and inflation is almost back to something we can feel comfortable with. Yet it is premature to conclude the economic coast is clear, and this will remain the case until the Federal Reserve lowers interest rates.

Given the Fed’s unprecedented interest rate hikes over the past couple of years, rates are high. By the Fed’s own accounting, the current federal funds rate of 5.5% is creating a significant economic headwind.

Yet Fed officials have made it clear they are in no rush to lower rates. They want to be certain they’ve put a stake in the heart of inflation. They prefer to risk waiting too long to lower rates — significantly weakening the economy or even precipitating a recession — than risk cutting rates too soon and allowing the economy and inflation to rev back up.

This is a difficult policy needle to thread, and the risk that the Fed won’t be able to manage it is the most serious threat to the good economy. Underlying this worry is the error policymakers made when waiting too long to raise rates early in 2022 when the economy was quickly rebounding from the pandemic. Inflation surged partly as a result, and the Fed was forced to catch up by aggressively ramping up rates, which it did through last summer.

Policymakers now risk committing another policy error, this time by waiting too long to begin cutting interest rates. It is unclear why Fed officials feel it necessary to take this risk. After all, they’ve all but achieved their dual mandates of a full-employment economy and low and stable inflation.

The unemployment rate has been firmly below 4% for two years straight, a testament to a full-employment economy. White, Black, or Hispanic, young or old, male or female, unemployment is steadfastly low across all demographic groups and the country. This is rare. The last time was over a half-century ago.

Of course, Fed officials should be cautious before they conclude they’ve slain inflation, but they appear to be afraid to declare victory. Indeed, annualized core inflation has been below their 2% target since last summer. The key reason inflation hasn’t receded even more is strong growth in the cost of housing. But all the trend lines on this look good because housing costs are ultimately tied to market rents, which have been flat to down over the past year and will remain so given the record number of multifamily units under construction.

Besides, this raises the question of the desirability of the 2% inflation target. When the target was effectively adopted in the mid-1990s, it seemed reasonable as the economy’s underlying growth and interest rates were higher. In a recession, the Fed cut could cut rates as much as needed to jump-start the economy. Not so now, as growth and interest rates are lower, and the Fed is more likely than not to hit the zero lower bound if it needs to cut rates in a downturn, hamstringing its effort to revive the economy.

If Fed officials were adopting an inflation target today, it would assuredly adopt a target meaningfully higher than 2%. While it would be imprudent for the Fed to change the inflation target before inflation was well in hand, it is also imprudent for the Fed to risk keeping rates too high for too long and sacrifice the economy to the altar of a 2% inflation target that few believe in.

Fed officials have unfortunately taken a rate cut at their March meeting off the table. While odds are that nothing will break if policymakers wait until their next chance in May, the longer they wait, the greater the risk that the financial system and economy will falter.

Indeed, the operating environment for banks and nonbank financial institutions is challenging: the inverted yield curve (short-term rates are higher than long-term rates) is putting pressure on net interest margins (the difference between the bank’s funding costs and their lending rates); the tightening in bank underwriting since last year’s banking crisis is slowing loan growth; credit quality is weakening, especially for commercial real estate loans; and regulatory costs have risen sharply following the crisis.

It is not difficult to see how a fissure in the financial system could quickly spread into a fault line, bringing on another crisis. This time, the Fed and other regulators may not be able to quickly calm panicked depositors and investors.

There is also reason to be nervous about the staying power of the strong economy. There is evidence that the job market is throttling back, including the recent sharp decline in hours worked, less hiring by businesses, less quitting by workers, and a steady decline in temporary jobs. Layoffs are low, but they are off bottom, and corporate layoff announcements have picked up.

The Fed should not dally much longer on cutting rates if it wants to avoid something going off the rails for reasons that are increasingly tough to fathom.