“If economists could manage to get themselves thought of as humble, competent, on a level with dentists, that would be splendid!” said John Maynard Keynes. The year of the 100-percent-chance-recession-turned-into-soft-landing-maybe ended up being the year the U.S. economy grew at a healthy rate of 3.1 percent – so much for a landing, if we have one at all; that should feel plenty humbling to economists everywhere.
By all accounts, there is steady good news coming the Federal Reserve’s way. Economic activity, driven by strong consumer demand, has been “expanding at a solid pace,” according to a recent Fed statement; unemployment remains low with robust job growth; and inflation has continued to slow down. The Fed’s preferred gauge of price growth – Personal Consumption Expenditures (PCE) price index – put the 12-month inflation rate at 2.6% in December, and there is even better news on inflation: over the six-months ending in December, prices rose at only a 2% annual rate, which would bring inflation in line with the Fed’s target. If the cooling continues – especially in housing prices, which have been slower to moderate – Fed policymakers could very well call it a victory.
And yet, the Fed seems to be in no rush to start cutting rates, as Chair Jerome Powell recently alluded to, saying, “With strong growth, strong labor market [and] inflation coming down, the committee intends to move carefully, as we consider when to begin to dial back the restrictive stance that we have in place.” The Fed decided last week, as it did in three previous meetings, to maintain rates where they have been since July at a 23-year high of 5.25% to 5.5%. While noting that risks to full employment and inflation are evening out, the Fed said it would still be looking for more data, and greater confidence, to make sure inflation will remain at that 2% goal.
Is this a case of “once bitten, twice shy”? Perhaps. Who could fault the Fed for wanting to be extra cautious, after being so heavily criticized for letting inflation run away? There is a vigorous debate over whether progress might stall ‘in the last mile’ and that perhaps the inflation rate will prove stickier as it gets closer to the 2% target.
Some risks do remain, even as the cooling trend continues. By several measures, including headline PCE, core PCE which excludes food and energy, and core PCE excluding housing on a one-month, three-month, and six-month annualized bases, inflation is down to 2% or below. Yet for services and, in particular, housing, price growth remains stubbornly high.
Figure 1
Furthermore, the January job report showed that, along with a strong labor market, wages were up by 4.5% over the past year, with wage growth appearing to accelerate over the last three months (Figure 2). It remains to be seen whether this rise in wages feeds into inflation, which will depend on profit margins, trends in productivity, and other factors.
Figure 2
If the downward trend in inflation sustains, that means real interest rates – nominal interest rates adjusted for inflation – are rising, which could put strain on the economy. In fact, the so-called Taylor rule, an approximate model that uses variables like price level, unemployment, and real income to project the optimal inflation rate, indicates the average Fed funds rate for the current quarter should be between 3.5% and 4.4%, rather than the current Fed funds rate of 5.5%.[1] The Taylor rule is considered by many experts to be a simplistic formula and the Fed employs a combination of various models, but that is still a big gap.
The pandemic reminded everyone a valuable lesson: supply-side issues can greatly impact inflation in ways that do not fit neatly into central banks’ traditional models that are used to set monetary policy. The Fed may have learned this lesson well, and is operating with the knowledge that the world remains an uncertain place. Monetary policymakers may be worried, quite rationally, that disruptions to the global supply chain due to ongoing geopolitical conflicts could repeat inflationary patterns seen during the pandemic.
The underlying question for the Fed: What is the neutral rate of interest – the interest rate that neither stimulates nor suppresses growth? Unfortunately, this is not a measure that can be directly observed or that the Fed can point to with confidence. The evidence that current rates are in fact too restrictive such that the situation requires restraint in Fed policy is, for now, not there. The strong January job report, which also indicated faster than expected wage growth, highlights the balancing act the Fed must continue. For the moment, there are no apparent costs for the Fed to wait for more evidence. While it could be very costly – and embarrassing – if the Fed acted too soon, cut rates now, and then had to reverse course.
[1] Based on Federal Reserve Bank of Atlanta’s Taylor Rule Utility which allows users to apply alternative Taylor rules under various measures of inflation and estimates of economic slack such as the output gap or the unemployment gap.
Why Is the Fed Waiting?