The US inflation rate, which had surged to over 9% two years ago, is now around 3%. Based on current trends, it should settle at 2.5%-3%, a range that most economists would deem consistent with financial stability, including a firm anchoring of inflationary expectations.
This good news would normally open the window for the central bank to cut interest rates when the Federal Open Market Committee, its top policy body, meets next week, given indications that the US economy is slowing more rapidly than many had expected. The Federal Reserve’s current mindset, however, means that it is more likely to limit itself to signaling the intention to lower rates when the FOMC meets on Sept. 17-18. Failing to ease policy in either July or September — an outcome that unfortunately can’t be ruled out — would constitute another policy mistake for a Fed seeking to restore its credibility after fumbling the initial response to building price pressures in 2021.
Part of the Fed’s hesitancy to cut rates is its lack of confidence that inflation will continue to decline to the 2% target rather than just settle at a stable 2.5%-3%. Maintaining monetary policy at a restrictive level would increase the probability of hitting that number but at the significant risk of causing undue damage to employment and the economy.
Indeed, it is far from clear that 2% is the right target. What was deemed appropriate for yesterday’s world of deficient aggregate demand and a series of beneficial developments on the supply side is less so for a world of global fragmentation, where supply chains are being rewired, and where we see persistent pockets of less flexible domestic supply.
Despite this, it’s highly unlikely that policymakers will revise the numerical inflation target after such a prolonged period of forecast errors and outcomes well above their goal. A more likely approach would be for the Fed to aim for a very gradual path to lower inflation from here, making it clear that its policy pursuits are now highly sensitive to labor market developments.
The risk of causing undue damage to the economy is amplified by the stress and strain already being felt by lower-income households and small businesses. Both have seen their pandemic-era cash reserves depleted at a time when it’s become far more expensive to service heavier debt loads. They can ill afford the effects of an overly restrictive Fed policy — especially when the lagged impact of higher rates is yet to be fully absorbed by the economy and the financial system as a whole.
In recent commentary, the Fed has finally moved to place greater emphasis on risks to the labor market in what it now deems a more balanced assessment overall. It is only a matter of time until policymakers shift further, to reflect greater concern about an undue weakening in employment and economic activity. The reason this isn’t happening more quickly — similar to the hesitancy to cut rates next week — is that policymaking has become overly data-dependent following the big 2021 mistake of rushing to dismiss rising inflation as simply “transitory.”
While waiting for September to cut is not a major issue in the grand scheme of things, a further delay would be of greater concern. And such a delay could easily transpire for an institution that lacks both confidence and sufficient strategic underpinnings. Indeed, all it would take is a negative data surprise in what are inevitably noisy high-frequency numbers.
The likelihood of a soft landing for the economy and preserving US economic exceptionalism would be considerably higher if the Fed were not encumbered by an outdated inflation target, an ill-suited monetary policy framework, and an overly data-dependent mindset. Instead, the probability is only in the 50% range in my assessment. And that is not a sufficiently comforting level, especially given high debt, worsening inequality and the range of non-economic uncertainties facing the US and global economies.
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