Mark Schiefelbein/AP Photo
Federal Reserve Chairman Jerome Powell speaks at the International Monetary Fund, November 9, 2023, in Washington.
The Federal Reserve closes its December rate-setting meeting today, with observers expecting it will keep interest rates unchanged at 5.25 to 5.5 percent, where they have been since August. In public comments, Fed governors have been reluctant to even discuss ending this pause and pivoting to rate cuts; at best, they have put any decision months into the future.
They remain in that posture even though inflation has eased much faster than anybody had reason to expect. Yesterday’s Consumer Price Index announcement for November reported that year-over-year headline inflation has fallen to 3.1 percent, with core inflation (which subtracts volatile energy and food prices) coming in at 3.5 percent. Just as the Fed reacted to unexpected surges in inflation with more than a year of rate hikes, a new paper from the research group Employ America suggests that the current disinflation should be met with rate cuts in 2024, sooner rather than later.
That’s because there are risks to the continued high costs of borrowing, which could lead to unemployment, recession, and a resumption of supply crunches in key sectors, and even exacerbate future inflation. This moves beyond whether or not Larry Summers was wrong about needing mass unemployment for inflation to go down (he was), and into understanding the next set of decisions to make for the economy. In “Three Motivations for Interest Rate Normalization,” authors Preston Mui and Skanda Amarnath offer a compelling case that those decisions have more to do with whether the labor market recovery remains strong, financial markets remain stable, and investment remains abundant.
As the title suggests, the authors supply three distinct cases for bringing down interest rates. First, they point to the possibility that the economy will falter. “As Silicon Valley Bank showed earlier this year, in this rate environment, risks can hit suddenly and without warning,” said Mui in an interview. “Unemployment often comes in suddenly, and you can’t wait until it’s actually happening to act.”
There is every reason to believe that, as we get further away from COVID lockdowns, the “FOMO” economy of pent-up consumption to make up for lost time will dissipate, especially with the pandemic-era safety net all but gone, built-up savings being drained, and liquid assets likely to drop in value. Economic growth is tracking at just 1 percent for the current quarter, and holiday hiring was sluggish. A previous Employ America paper from November explained that job quits, often a sign of a pro-worker labor market, have been falling off, and the wage premium for changing jobs is lower. Total labor income, a measure of how much discretionary spending can be managed in an economy, is also likely to be down next year.
Recessions don’t always come with a flashing red signal, Mui explained. “If you look at past recessions, they often begin with a layoff wave at the beginning. But you can have a recession if hiring slows sufficiently.” Inattention to those risks can be fatal. The paper cites a 2007 quote from Tim Geithner, then the vice chair of the Fed, who at the cusp of the Great Recession, when presented with a forecast that explicitly warned of rising unemployment, refused to reduce rates because of concern that “the risk that inflation will fail to moderate sufficiently … remains significant and material.” At the time, inflation was at 2.7 percent.
A “wait and see” approach is actually damaging, because recession risks can sneak up on policymakers.
Meanwhile, the negative effects of high interest rates on mortgages or corporate loans will only grow worse. Many borrowers locked in lower rates before they rose, but eventually households will need to move, or corporate debt will mature and roll over. So while we have a lot of remnants of the low-rate environment, that will shift as more people pay more to borrow, which can depress economic activity.
The second rationale for rate cuts is the consistency argument. The idea of raising interest rates to fight inflation may have made some sort of sense to businesses, so they could plan accordingly. If inflation is under control, and rates remain high, it not only reveals what part of the Fed’s dual mandate actually matters, but also creates business uncertainty, Mui said. “If interest rate policy is not predictable, it’s difficult to plan around that.” It doesn’t help the Fed’s credibility to confuse real-life business owners with inconsistent reactions to inflation changes.
Finally, the authors point out something I’ve noticed myself, that the high-interest-rate environment really damages capital-intensive industries and slows down investment. Private research and development actually shrank in the last quarter of the year, and businesses are cutting investment and capital expenditures because of the cost of financing, particularly in clean energy, where the costs are heavy at the outset. If it weren’t for public investment from the CHIPS Act and the Inflation Reduction Act, investment would be even worse.
It’s not just the green transition being affected. While lots of housing is getting completed, housing starts, where the up-front costs are greatest, have plummeted in the past few months. One of the biggest parts of the inflation calculation is the cost of shelter, and the Fed’s rate hikes are severely cramping the pipeline of future housing units, which puts upward pressure on prices. These deficiencies in housing and energy will have impacts well into the future.
“When [Fed Chair] Powell talks about supply, he says that supply will recover or not, and Fed will react appropriately. That’s too simplistic,” Mui said. “The Fed needs to think about supply-side in terms of how monetary policy affects it.” In this sense, it might be worth cutting rates now to ensure abundant supply later. Cutting rates is something of a future inflation-fighting tool.
Putting this together, the authors suggest that rate cuts should be front-loaded, just as increases were when inflation went up. Rates should fall in a manner consistent with inflation deceleration. Softening inflation, which may have even more room to run as price pressures for housing fall in the near term—there are a lot of multifamily units about to come onto the market—gives the Fed space to think about lower interest rates, without worrying about sparking a new bout of price increases.
A “wait and see” approach is actually damaging, because recession risks can sneak up on policymakers, and because the pain of maintaining rate hikes grows with each passing day. I think you see it in public economic sentiments: People are mad about the economy for a lot of reasons, but financing charges that put houses and cars out of reach are certainly among them.
Other progressive economic organizations are pressuring the Fed to pivot. “Now that it’s abundantly clear we don’t need to throw people out of work to bring down prices, chair Powell should course correct and begin cutting rates before we suffer further damage to the housing market or continue to ice investments in the green transition,” said Lindsay Owens, executive director of the Groundwork Collaborative.
Employ America consciously uses that frame of interest rate normalization. It is not normal for the central bank to keep the policies intended to fight inflation in place long after inflation has been tamed. The hallowed (and what some economists as recently as a few months ago called mythical) soft landing, they say, can only be reached with normalization on all sides, including in the federal funds rate. When the data changes, so should Jerome Powell.
