The "worst possible outcome" for the Fed is an unnecessary recession, not reversing a cut

The Fed must decide when and how much to cut rates this year. Several Fed officials in recent weeks have said they will move slowly. What are they thinking?

The Fed’s Eccles Building, under renovation. Photo credit: Claudia Sahm.

In today’s post, I explain why the Fed should cut the federal funds rate now and why they are unlikely to do so before May. Today’s public post is the big picture, and next week’s paid post will be more technical, albeit accessible. The FOMC’s next vote is on January 31.

The Fed faces many challenges. After hiking the federal funds rate aggressively by 5 1/4 percentage points from March 2022 through July 2023, it’s time to start cutting.

Inflation has decreased substantially from its peak in the summer of 2022. The consensus is that inflation ended 2023 with a two-handle on both total and core, at 2.6% and 2.9%, respectively. (The Bureau of Economic Analysis will publish the numbers on Friday.)

That’s a massive improvement in inflation—down from a peak of 7.1% for total and 5.6% for core. Moreover, there is no reason that the last mile must be the hardest. In addition, families are convinced that inflation is coming down. Here from the Surveys of Consumers out of the University of Michigan (#goblue) on inflation expectations:

Year-ahead inflation expectations softened to 2.9% after plunging in December. The current reading is the lowest since December 2020 and is now within the 2.3-3.0% range seen in the two years prior to the pandemic. Long-run inflation expectations edged down to 2.8% falling just below the 2.9-3.1% range seen for 26 of the last 30 months.

Inflation expectations are central to the Fed’s outlook for inflation, and Michigan is their preferred measure. This is undeniably good news. (The best news in the survey was a massive two-month surge in sentiment. The vibecession is over.)

Current readings on inflation are not far from the Fed’s 2% target, and inflation expectations look good. But is that good enough for the Fed to cut? Probably not. And while there is a logic to the Fed’s approach, delaying could cost us millions of jobs and trillions of dollars in spending and investment. Plus, the high interest rates are putting stress on credit markets. The Fed is the biggest risk to the soft landing.

The Fed is afraid.

Inflation has come down across most categories, and if anything, disinflation shows signs of speeding up, but the Fed is worried inflation might come back. Anything is possible, and vigilance is essential, but there is more to the Fed’s caution.

The Fed doesn’t want to cut until they are sure inflation won’t return. If it were to come back after it cuts, the Fed would have to raise rates, which it sees as problematic. Here are three recent comments from voting members (out of 12) on the Federal Open Market Committee exemplifying the concern:

The key thing is the economy is doing well. It’s giving us the flexibility to move carefully and methodically.

So we can see how data comes in and see if progress is being sustained. The worst thing would have is if it all reverses, and we have already started to cut.

So we really want to see evidence that this progress, this trend we are seeing in the real data, and the inflation data continues. I believe it will but we have to see that before we start making decisions.

~ Chris Waller, Governor at the Board, speech and Q&A, January 2024.

The worst outcome, [Bostic] said, would be for policymakers to lower rates and have to raise them again later if inflation moves higher.

“I’m expecting it’s going to be bumpy and because of that bumpiness I feel like we’ve got to be careful. We do not want to go on these up and down or a back and forth pattern.

I want us to be absolutely certain that inflation is where we need it to be before we move too dramatically.”

~ Raphael Bostic, President of the Atlanta Fed, speech and Q&A, January 2024.

I think March is probably too early in my estimate for a rate decline because I think we need to see some more evidence … I think the December CPI report just shows there’s more work to do, and that work is going to take restrictive monetary policy.

Obviously we don’t want to see the progress in inflation stall out but I don’t think this report suggests that’s happening. It just suggests we have more work to do, and we’re committed to doing it.

~ Loretta Mester, President of the Cleveland Fed, interview, January 2024.

The idea that the worst thing that the Fed can do is cut and then raise is dangerous.

If nothing else, the past four years should have taught us that the world can change rapidly and defy our expectations. Monetary policy takes time to work through the economy, so the Fed must also draw on forecasts. Reality can be cruel to forecasts, but unlike other policymakers, the Fed can turn on a dime when reality strikes.

Moreover, many examples of reversing course exist, even outside of financial crises. Most recently, the Powell Fed cut three times starting in the summer of 2019 after raising rates through the end of 2018, calling it a “mid-cycle adjustment.” The Greenspan Fed cut in late 2002 and early 2003, citing worries about a slow recovery from the 2001 recession, and then began raising rates steadily in the summer of 2004. Even the Volcker Fed made small adjustments along the way.

One could view these as mistakes, but all three Chairs remained widely respected central bankers. It’d be nice if the world rolled out according to plan. It’d be nice if policymakers had a crystal ball. But that’s not how this works.

Wake up, Fed. It’s not the 1970s.

Where does the Fed’s fear of cutting and then having to raise due to inflation come from? As with most fears in this cycle, it’s from the 1970s. I wrote about it in 2022.

I am still writing about it in 2024, which is frustrating because 2023—massive disinflation and a low unemployment rate—happened and is entirely at odds with the 1970s. The twist is that most people now agree that inflation in the 1970s was not like today’s, but somehow, the Fed remains fixated on monetary policy mistakes then.

To understand the Fed today, you must look at the world the way the Fed does. To do that, you must know its history and the cannons of money/macro. Former Fed Chair Ben Bernake’s book, 21st Century Monetary Policy, and former Fed Vice-Chair Alan Blinder’s book, A Monetary and Fiscal History of the United States 1961-2021, are excellent, well-written resources to do so.

Here is Bernanke:

This stop-go pattern [of the Arthurs Burns Fed]—tightening policy when inflation surged but then easing as soon as unemployment began to rise—proved ineffectual and allowed inflation and inflation expectations to ratchet up.

Burns recognized that the state of the economy in the stagflationary 1970s was far from satisfactory. He believed that inflation was costly and destabilizing but then, so was unemployment. He did not think the public would tolerate unemployment high enough to fully control inflation using monetary policy alone …

Here is Blinder:

Of the two main macro variables, inflation commanded center stage in 1973. After the 1972 election [and cutting rates before Nixon’s re-election], the unemployment rate drifted slowly downward, making it less salient both economically and politically. But the inflation rate soared, from just 3.4% in the twelve months ending in November 1972 (with price controls in effect) to a startingly 8.3% in the twelve months ending in November 1973, the highest inflation rate in the United States since 1951.

With the election in the rearview mirror, the Burns Fed reacted strongly to higher inflation, boosting the federal funds rate from 5.1% in November 1972 to 10.8% in September 1973.

If a central bank eases monetayr policy [cuts rates] to fight stagflation [high inflation and high unemployment]. that would exacerbate the inflation problem .. the Authur Burns Fed vacillate [through the rest of the 1970s].

Sounds sensible for today, right? Wrong.

A global pandemic kicked off this inflation cycle, which bears no resemblance to the cycle in the 1970s. One could plausibly argue it did in the summer of 2022—risks of embedded inflation and an inflationary spiral. But after 2023, with a massive disinflation to less than a percentage point of the 2% target and inflation expectations firmly anchored, it’s on the Fed and anyone else clinging to the Burns Fed to explain themselves.

The reality now—not in the 1970s—should drive policy now. The Fed fears losing its credibility as an inflation fighter by cutting too soon, but it’s a two-sided risk. No one wants to be Arthur Burns, and no one should want to be the upside-down Arthur Burns. Cutting too late, too little, and causing an unnecessary recession would also be a hit to the Fed’s credibility.

The Fed’s fears are mind-boggling. Markets view the Fed as a credible inflation fighter (though possibly overzealous now). Moreover, markets have held that view of credibility throughout the cycle and expected inflation to come down, and consumers, too. So, who is the judge of credibility that the Fed is worried about? It’s the elite macroeconomists and former Fed officials who will write the history books.

Here’s one of many examples of where credibility also looms large:

The moment they turn, or announce they’re going to turn, is going to be a seismic moment … And for that reason, they probably need to be very deliberative and careful about getting to that point.

Fed officials probably need to wait until they see some overwhelming evidence of inflation being locked in low, or see some real evidence of the economy turning over.

Policymakers need to make sure that progress on bringing inflation down becomes entrenched and locked in.

~ Larry Summers, Bloomberg TV, December 2023.

But again, a Time Warp back to the 1970s risks poor policy decisions. The people who erroneously told us inflation was like the 1970s are telling us that monetary policy today must be based on the ‘received wisdom’ of the 1970s.

Fears about credibility and the 1970s have a stranglehold on the Fed. It will likely delay until it’s painfully obvious that inflation is under control, which may be too late for the economy and credit markets.

The worst possible outcome is an unnecessary recession.

The dual mandate is the law: stable prices and maximum employment. Full stop.

A recent troubling refrain from Fed officials is that because the economy is doing so well, they have the luxury of time to become confident about inflation before cutting rates. The dual mandate is not consistent with that logic. Inflation and employment are co-equal, and inflation should not be put above employment, particularly when inflation is so close to its target.

Indeed, the labor market, consumers, and other bright spots in the economy create a margin of error for the Fed, as I have argued.

Willfully using that margin is unacceptable. No buffer can withstand everything. There are worrisome signs in the labor market. For example, the employment gains have narrowed to industries like state and local government and health care and slowed overall. It is also unclear whether the gains in labor force participation last year will hold up and continue. Now is not the time to lean on the labor market. Most importantly, these are people’s livelihoods, not a security blanket for the FOMC.

Rolling the dice on the labor and credit markets risks an unnecessary recession, which is far worse than cutting and then raising.

In closing.

If you look at the data and listen to the Fed’s words, like they won’t wait until 2% to cut or believe in the dual mandate, it’s hard not to ask why they aren’t cutting.

Looking at the data, the Fed should cut next week. Looking at the data through Fed-colored glasses, May is the earliest cut. The American people are trying their best to land this plane softly. If the Fed doesn’t get with it soon, we must land it despite it. It does not have to be that way. Cut.