Fed Official says rate cuts could be needed next year to prevent over-tightening
A Federal Reserve official said it is appropriate for the central bank to begin looking ahead to lowering interest rates in 2024 because of how inflation has improved this year.
San Francisco Fed President Mary Daly said her outlook for interest rates and inflation was “very close” to the median of projections from 19 Fed officials last week. Most of them penciled in at least three rate cuts next year amid a faster decline in inflation than they anticipated.
“We’re acknowledging progress when progress is there,” Daly said in an interview Monday.
Daly said that if inflation continues its steady decline of recent months, the Fed’s benchmark interest rate “will still be quite restrictive even if we [cut rates] three times next year.”
Daly said she is watching the effect that restrictive policy has on the labor market. When the unemployment rate starts to rise, it tends to go up by a lot and not by only a little bit, Daly said. As a result, “we have to be forward looking and make sure that we don’t give people price stability but take away jobs.”
Daly said she thought interest-rate policy was in a “good place” to achieve that result. In a notable shift, she said the Fed’s focus now needed to turn toward paying attention to both sides of its mandate.
“There is more work to do, and at this point, that work includes not only focusing on bringing inflation down to 2%…but also recognizing that we want to continue to do this gently, with as few disruptions to the labor market as possible,” she said.
Government data released last week indicated very mild inflation in November as measured by the central bank’s preferred inflation gauge, which the Commerce Department will release on Friday. The figures suggest inflation excluding volatile food and energy costs will reach or even dip below 2% on a six-month annualized basis, and the 12-month rate could drop to 3.1% in November. The Fed targets 2% annual inflation.
Daly said rate cuts would be appropriate to prevent inflation-adjusted or “real” rates from rising by holding nominal rates steady as inflation declines. Allowing real rates to increase would create an elevated possibility “that we could over-tighten quite easily, and so that’s what I’m mindful of,” said Daly, who will become a voter on the Fed’s rate-setting committee next year.
Stocks surged and bond yields tumbled last week after the Fed held interest rates steady and officials projected three rate cuts for 2024. While Fed Chair Jerome Powell said it was too early to say the central bank was done raising rates, he fueled a rally when he also volunteered that officials were preparing to focus on when to lower rates.
His comments sent investors in interest-rate futures markets to increase their bets on earlier and deeper rate cuts next year.
Daly said it was too soon to speculate at which meetings the Fed might change its policy stance next year. “Right now, I’m really focused on how well things have evolved in 2023,” she said.
While much of the initial decline in inflation this summer stemmed from supply-chain healing, more recent declines appear to have been driven by a cooling in demand-driven components, she said.
A model maintained by the San Francisco Fed suggests two thirds of the decline in core inflation had been related to changes in demand. “To me, that’s a material development,” said Daly. “That means we have monetary policy working.”
Daly said it was possible inflation could show greater signs of persistence in the months ahead and that the economic outlook could shift in a way that would call for the Fed to keep rates higher for longer. On the other hand, inflation could decline more rapidly or the labor market could weaken more meaningfully than it has, justifying easier policy, she said.