Federal Reserve Flight 2024 Hasn’t Landed Yet

Financial markets have lately been intensely focused on the US Federal Reserve’s next moves: How soon will it start cutting interest rates, and how low will it take them this year?

That’s really hard to answer, but I can offer some insight into what will drive the Fed’s decisions.

Earlier this year, the Fed was expected to lower its short-term interest-rate target by 150 basis points this year, starting in March. Now, after a strong jobs report, an uptick in manufacturing activity and an unexpectedly high January inflation reading, March is off the table and markets are putting less than 50% odds on a cut in May.

So when might the Fed finally move? Certainly officials are concerned about maintaining growth: With inflation at more reasonable levels and people’s expectations of further price increases under control, they can put more weight on the “full employment” part of their mandate. Still, if the economy remains strong and the labor market tight, they can hold rates higher a bit longer, to ensure inflation gets sustainably back down to 2%. Also, markets play a role: As long as they expect rate cuts, easier financial conditions will support growth — though of course this has limits, as the gyrations surrounding the latest inflation report demonstrated.

The Fed must also grapple with some deeper structural questions. First, why is the economy so strong? Maybe previous monetary tightening has yet to fully play out, or maybe the abatement of frictions in supply chains and the labor market has been providing a transitory boost to growth. Fed Chair Jerome Powell has suggested that both are true. If so, the economy will soon slow enough to tilt the balance to rate cuts.

There is, however, a competing explanation: Maybe monetary policy isn’t all that tight. That is, maybe the neutral, inflation-adjusted interest rate — the level that neither stimulates nor damps growth — is higher than Fed officials’ estimate of 0.5%, meaning that the current federal funds rate is less restrictive of growth. I think this is right: Large and chronic fiscal deficits, together with public subsidies for green investment, have pushed up the neutral interest rate. If so, the Fed should hold rates higher for longer.