Source: Jin10 Data

A year ago, the Fed raised interest rates to 5% or more and was determined to achieve two things: significantly reduce inflation and cool down the labor market.

It seems to have succeeded now. According to its preferred PCE data measure, inflation has fallen from 4.3% at the time to around 2.6% currently, the biggest drop since 1984, and is just a stone's throw from the Fed's 2% target. Meanwhile, the unemployment rate has risen from 3.6% to 4.1%, a rarity outside of economic recessions.

However, the Fed seems unwilling to declare victory just yet. This week, Fed Chair Powell declined to reveal when or whether the Fed will cut interest rates, while the New York Fed President said he needs more data and Fed Governor Waller only acknowledged that the rate cut is "getting closer and closer." The market expects the Fed to cut rates in September.

The Fed's silence is understandable. Although it likes to announce its plans in advance, it is now being twice as cautious after seriously exaggerating its inflation forecast earlier.

But if the Fed is really data-dependent and believes in its own forecasts, it should have no problem cutting rates now. At the very least, the option should be actively discussed at the meeting in two weeks. Cutting rates does carry risks, but waiting does as well.

"Once bitten, twice shy."

The Fed's caution goes back to its infamous prediction in 2021 that inflation would be transitory. At that time, GDP growth was still well below pre-pandemic trend levels, and the unemployment rate was higher than its long-term "natural" level. According to models used by the Fed and private forecasters, this weakness meant that even massive fiscal stimulus should not push inflation up substantially, especially considering that public expectations for inflation were anchored around 2%, roughly the same level as 20 years ago.

Forecasters missed how the pandemic would disrupt supply chains and work patterns, and force millions of people out of the labor market. When demand spurred by the stimulus plan met with these supply constraints, prices soared and wages quickly followed suit. As the unemployment rate fell below 4%, job openings soared, and the Fed worried about a wage-price spiral, raising interest rates to between 5.25% and 5.5% currently.

Higher interest rates cooled demand, but the main reason for the decline in inflation was the recovery of the supply chain and the fading fiscal stimulus measures. Inflation shocks in recent years have led to sharp increases in prices and wages, but they have proven to have a mainly temporary impact on inflation.

Therefore, the interest rate that seemed appropriate a year ago now appears to be too high. Economists have devised several simple formulas, such as the "Taylor rule," as monetary policy guidelines, which show that interest rates should be lower.

The risk of waiting

Although the US economy has slowed moderately this year to around 2% growth, it remains healthy. Currently, the unemployment rate in the US is 4.1%, indicating that the labor market is neither too hot nor too cold. The stock market is at record highs. This does not look like an economy that needs lower interest rates.

But there are also many warning signs. Historically, when the unemployment rate has risen this much, it tends to continue to rise. The increase in this data may reflect an increase in labor supply, which may be immigrants who lack permanent legal status. According to the Labor Department's wage survey, labor demand appears to be stable, with monthly employment growth exceeding 0.2 million this year. But another household survey shows weak job growth, and the real situation is not yet clear.

Higher interest rates have not greatly slowed economic growth, as many homeowners and businesses locked in rates when interest rates were low. But the pressure is building: credit card and auto loan delinquency rates are now higher than pre-pandemic levels.

The risk of cutting interest rates

The biggest risk the Fed faces now is that inflation may not be beaten. However, a resurgence does not seem likely. In retrospect, the past few years of shocks seem to have triggered a series of one-time increases in inflation. For example, the semiconductor shortage caused a massive drop in auto production in 2021, driving up prices. New car prices peaked early in 2022 and then fell back nine months later, while auto insurance prices lagged behind for two years.

This is one of the reasons why inflation has fallen so unevenly, including the alarming rise last winter and the hard-to-identify underlying trends.

However, while these shocks may temporarily push up inflation, unless other conditions are in place, particularly tight labor markets, inflation should not be sustainable.

The vacancy rate has dropped from two unemployed workers per job opening in early 2022 to a more normal 1.2. The unemployment rate is rising. According to a survey of corporate compensation plans by consulting firm WTW, annual wage growth in March 2022 has fallen from 5.9% to 3.9% in June and will fall further next year.

Although core inflation is unlikely to accelerate again, it may stagnate around its current level of 2.6% rather than fall to 2%. In fact, as the base effect approaches, the year-on-year growth rate of inflation may rise rapidly.

However, if this situation occurs, the Federal Reserve can completely stop cutting interest rates. This is what the Federal Reserve's "data dependence" means, that interest rates will still be at a restrictive level.

Political factors

Officials insist that the November election is irrelevant to their decision, and this is understandable as no matter what they do, one party will feel uneasy. Republican candidate Trump said in an interview that the Fed should not cut interest rates from now until the election. If the Federal Reserve does not lower interest rates, Democrats will also criticize it.

However, Goldman Sachs chief economist Hazus said that in terms of the extent to which political factors affect Federal Reserve decisions, they advocate making decisions as far away from elections as possible, that is, cutting interest rates now instead of September.

Currently, the Federal Reserve may not cut interest rates within two weeks, but will hint at preparing to cut interest rates in September. This should keep the market calm, but cutting interest rates and expecting interest rate cuts are completely different things.

Economists surveyed on average believe that there is a 28% chance of a US economic recession next year, which is not high, but higher than normal levels. If this risk becomes a reality, even if the Federal Reserve delays cutting interest rates by a few months, it will still have an impact.

Editor/Lambor