I’ve long been in the “higher for longer” camp, insisting that the US Federal Reserve must hold short-term interest rates at the current level or higher to get inflation under control.
The facts have changed, so I’ve changed my mind. The Fed should cut, preferably at next week’s policy-making meeting.
For years, the persistent strength of the US economy suggested that the Fed wasn’t doing enough to slow things down. The government’s pandemic-era largesse left people and businesses with plenty of cash to spend. The Biden administration’s vast investments in infrastructure, semiconductors and the green transition boosted demand. Easing financial conditions — particularly a surging stock market — increased wealthier households’ propensity to consume. Containing the resulting inflation, it seemed, would require sustained monetary tightening from the Fed.
Now, the Fed’s efforts to cool the economy are having a visible effect. Granted, wealthy households are still consuming, thanks to buoyant asset prices and mortgages refinanced at historically low long-term rates. But the rest have generally depleted what they managed to save from the government’s huge fiscal transfers, and they’re feeling the impact of higher rates on their credit cards and auto loans. Housing construction has faltered, as elevated borrowing costs undermine the economics of building new apartment complexes. The momentum generated by Biden’s investment initiatives appears to be fading.
Slower growth, in turn, means fewer jobs. The household employment survey shows just 195,000 added over the past 12 months. The ratio of unfilled jobs to unemployed workers, at 1.2, is back where it was before the pandemic.
Most troubling, the three-month average unemployment rate is up 0.43 percentage point from its low point in the prior 12 months — very close to the 0.5 threshold that, as identified by the Sahm Rule, has invariably signaled a US recession.
Meanwhile, inflation pressures have abated significantly after a series of upside surprises earlier this year. The Fed’s favorite consumer-price indicator — the core deflator for personal consumption expenditures — was up 2.6% in May from a year earlier, not far above the central bank’s 2% objective. The June reading, coming next week, is likely to reinforce this trend, judging from already reported data that feed into the core PCE calculation. On the wage front, average hourly earnings were up 3.9% in June from a year earlier, compared with a peak of nearly 6% in March 2022.
Why, then, are Fed officials strongly hinting that there will be no rate cut at next week’s meeting?
I see three reasons. First, the Fed doesn’t want to be fooled again. Late last year, a moderation in inflation turned out to be temporary. This time around, further progress in reducing year-over-year inflation will be difficult, due to low readings in the second half of last year. So officials might be hesitant to declare victory.
Second, Chair Jerome Powell might be waiting in order to build the broadest possible consensus. With markets already fully expecting a cut in September, he can argue to doves that delay will have little consequence, while building more support among hawks for the September move.
Third, Fed officials don’t seem particularly troubled by the risk that the unemployment rate could soon breach the Sahm Rule threshold. The logic is that rapid labor force growth, rather than a rise in layoffs, is driving the increase in the unemployment rate. This isn’t compelling: The Sahm Rule accurately predicted recessions in the 1970s, when the labor force was also growing rapidly.
Historically, deteriorating labor markets generate a self-reinforcing feedback loop. When jobs are harder to find, households trim spending, the economy weakens and businesses reduce investment, which leads to layoffs and further spending cuts. This is why unemployment, having breached the 0.5-percentage-point threshold, has always increased a lot more — the smallest rise was nearly 2 percentage points, trough to peak.
Although it might already be too late to fend off a recession by cutting rates, dawdling now unnecessarily increases the risk.
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