Plummeting Inflation Raises New Risk for Fed: Rising Real Interest Rates
Federal Reserve officials start the year with a problem they would ordinarily love to have: Inflation has fallen much faster than expected.
It does, nonetheless, pose a conundrum. The reason: If inflation has sustainably returned to the Fed’s 2% target, then real rates—nominal rates adjusted for inflation—have risen and might be restricting economic activity too much. This means the Fed needs to cut interest rates. The question is, when and by how much?
The Fed won’t cut at its two-day meeting ending this Wednesday because the economy has been growing solidly. While inflation excluding food and energy on a monthly basis has been at or below 2% in six of the last seven months, the Fed wants to be sure that can be sustained before cutting rates.
Instead, Fed officials are likely to take a symbolically important step this week by no longer signaling in their policy statement that rates are more likely to rise than fall. Ditching this so-called tightening bias would affirm that officials are entertaining lower rates in the coming months.
Normally, the Fed cuts interest rates because economic activity is slowing sharply. Not this time: Growth remained surprisingly robust through the end of last year. Rather, they are mulling whether softening inflation means real interest rates will be unnecessarily restrictive if they don’t act.
Militating against a rate cut soon: Bond yields have fallen and stocks have risen, which could bolster economic activity and consumer spending. For that reason, officials could wait until May or even later to cut, said William English, a former senior Fed economist who is a professor at Yale School of Management.
On the other hand, “if they get genuinely reassuring inflation numbers and the real economy seems to be slowing a bit, I could see them getting comfortable with a cut in March,” he said.
The case for cutting later
Policymakers might want to move carefully to lower rates because they are not sure if the recent inflation cooling will last or if the economy will rev up in a way that sustains somewhat higher inflation. Several officials have said they want to avoid at all costs cutting rates only to have to raise them again.
Dean Maki, chief economist at hedge fund Point72 Asset Management, thinks the Fed will wait until June to cut interest rates because growth and hiring will exceed its expectations this year.
Concerns that lower inflation will raise real rates are misplaced because it will also boost purchasing power, consumer confidence and spending, said Maki. “Growth strengthens when inflation falls. I can’t think of examples in the last several decades where growth weakens after inflation falls,” he said.
It is also possible the economy can tolerate higher rates than before. In December, most officials thought the neutral rate, which balances supply and demand when the economy is operating at full strength, was 2.5%, well below the actual rate, which has been between 5.25% and 5.5% since July. That implies rates are highly restrictive, yet the economy hasn’t behaved that way.
Officials “have tended to let the data tell them they’re overly restrictive rather than rely” on estimates of neutral, said Maki.
The case for cutting sooner
Others warn that waiting for the data to signal the Fed is too restrictive will require the type of aggressive cuts reserved for an economy falling into recession, as occurred in 2001 and 2007. They point to latent risks from heavily indebted companies, especially in real estate, which locked in lower interest rates earlier in the pandemic. Those borrowers might struggle as that debt is refinanced at higher rates.
The argument for lowering rates sooner goes like this: Fed officials raised rates rapidly to a 22-year high and telegraphed plans to keep them there for a while because they worried it would take years for inflation to fall back to their target. But inflation has fallen much faster than they expected. Prices excluding food and energy rose at a 1.9% annualized rate between July and December, down from 4% in the previous six-month period.
“We made a very aggressive tightening. Look not only at the supply that came back but also the demand that came down last year,” said Esther George, who served as president of the Kansas City Fed from 2011 until last year. There is potentially “a lot of room” to cut rates before they are in neutral territory again.
Officials are also shrinking their $7.7 trillion asset portfolio—sometimes called “quantitative tightening” or QT—faster than they did five years ago. “They’ve got QT going on steroids, still,” said George.
Policymakers are right to worry that cutting rates then raising them again would blemish their credibility, said George. But she said the greater risk now is that taking too long to cut rates causes damage to the labor market that is hard to repair.
In November, for example, the hiring rate in the U.S. dropped to its lowest level in 10 years, a sign more companies might feel they are overstaffed. “The labor market is such a tricky one,” said George. Before a downturn, “it always looks like it’s not too bad, and then it goes south quickly.”
Officials raised rates because they worried high inflation would lead businesses and consumers to expect high prices to persist, creating a self-fulfilling cycle and a rerun of the 1970s. But it increasingly looks as if a series of shocks generated a one-off surge in prices across successive sectors—goods, housing, services and labor, said Dario Perkins, an economist at GlobalData TS Lombard in London. That gave the impression inflation’s increase was persistent when in fact it wasn’t.
“You should be able to cut interest rates quite rapidly if that scary 1970s dynamic isn’t happening, and it isn’t happening,” he said. “The lesson of the last 12 months is that we don’t really need pain to get inflation down to tolerable levels.”
