Key Points
- Fed’s Dual Mandate: The Fed must balance inflation control with employment support, focusing on labor market strength.
- Soft Landing Challenge: Following successful interventions in 1984 and 1994, a preemptive rate cut could prevent a recession.
- Risks of Inaction: Maintaining high rates too long could trigger a recession, harming the economy rather than naturally slowing it.
- Housing Market Warning: High rates have led to significant declines in housing affordability, reflecting broader economic pressures.
- Political Timing: The Fed faces pressure to act before the 2024 election to avoid politically charged, last-minute economic interventions.
The Federal Reserve’s approach to interest rate adjustments is always a hot topic, especially when the economy is at a crossroads. Jay Powell, the chair of the Fed, has recently hinted that it’s time to revisit monetary policy, suggesting the need for a shift. Yet, the specifics of this move—how steep and fast it should be—are still up in the air. The consensus is that we may see cuts, but to what extent? With the next presidential election looming and economic factors hanging in the balance, the Fed may need to act decisively and soon.
The Fed’s Dual Mandate and Labour Market Focus
Unlike most central banks, the Federal Reserve operates with a dual mandate: price stability and maximum sustainable employment. Powell has expressed confidence that inflation will reach the desired 2% target, but the focus has shifted to the labor market. The Fed’s recent statements indicate a keen interest in supporting employment, which may hint at the urgency to reduce rates sooner rather than later.
The labor market plays an outsized role in determining the timing of monetary policy shifts. Powell has evoked sentiments similar to those of Mario Draghi in 2012 when Draghi promised to do WIT to save the euro. Powell’s stance echoes that same commitment, only this time to foster a strong labor market in the US. This determination suggests that rate cuts could arrive sooner if the Fed wants to prevent any significant damage to employment figures.
The Soft Landing Challenge
Achieving a soft landing—where the economy slows down just enough to avoid recession while taming inflation—is often seen as the holy grail of monetary policy. However, it’s no easy feat. History shows that such landings are rare, but they have occurred. Powell has pointed to soft landings in 1965, 1984, and 1994 as prime examples. In these instances, the Fed adjusted rates preemptively before the labor market saw a significant decline.
For instance, in 1984, the Fed cut rates by over three percentage points in just four months, and in 1995, it eased rates gradually by 0.75 points over seven months. These moves helped avoid sharp downturns. Notably, the unemployment rate had only slightly increased in these cases before the Fed intervened. The lesson here is that a timely policy shift can help avoid a hard landing, and the Fed may need to adopt such a strategy again to maintain economic momentum.
The Risks of Inaction
But what happens if the Fed waits too long to adjust its stance? If the central bank keeps rates high for too long, it risks causing a recession—a concern voiced by many economists. The late Massachusetts Institute of Technology economist Rudi Dornbusch famously remarked that postwar expansions were often “murdered” by the Fed. It wasn’t a natural economic downturn that ended growth but an overly restrictive monetary policy.
Today, there are clear signals that the current rate of 5.25% to 5.50% is significantly higher than what the economy needs, especially as inflationary pressures ease. The Fed’s estimates suggest that a neutral rate—the level at which interest rates neither stimulate nor restrict the economy—falls between 2.5% and 3.5%. This indicates that the current policy is overly tight, and maintaining it risks damaging the economy further.
Housing Affordability: A Warning Sign
One of the areas where the Fed’s restrictive policy is most evident is the housing market. Affordability has taken a nosedive, with current conditions reminiscent of the mid-1980s. The NAR reports that housing affordability is at its lowest point in decades, underscoring the real-world impact of higher interest rates. Housing often acts as a bellwether for broader economic health, directly affecting consumer confidence and spending.
The tightness in the housing market isn’t just a problem for first-time homebuyers—it reflects the broader economic impact of high interest rates. The Fed’s rate hikes have effectively curbed inflation, but they’ve also contributed to worsening affordability in critical sectors like housing. This disconnect between monetary policy and its real-world implications makes a compelling case for the Fed to adjust its stance.
The Political Pressure and the Election Factor
With the U.S. presidential election on the horizon, one might wonder how much room does the Fed have to manoeuvre? After all, central banks are supposed to remain politically neutral, and any major policy shifts close to an election could be considered controversial. However, if the Fed waits too long to act, it risks appearing reactive rather than proactive. Worse yet, an economic downturn or a market event could force the Fed to take emergency measures, likely appearing even more disruptive.
The September policy meeting presents the last real opportunity for the Fed to make significant adjustments before election season heats up. By resetting rates now, the Fed could avoid the political complications of a last-minute intervention just before voters head to the polls. In this sense, timing is crucial—not just for the economy but also for the Fed’s independence.
The Case for a Swift and Meaningful Rate Cut
The time has come for the Fed to shift course. The lag in monetary policy transmission means that the effects of rate cuts would take several months to materialize fully. If the Fed delays too long, it risks reacting to deteriorating conditions rather than forestalling them.
By cutting rates now, the Fed can ensure it remains ahead of the curve, maintaining control over the economic narrative rather than allowing events to dictate its moves. A meaningful reset of interest rates would preserve employment and safeguard the Fed’s credibility and independence. Maintaining the current, overly restrictive stance risks turning Fed policy into a passive-aggressive approach that waits for signs of weakness rather than preventing them.
In conclusion, while it may seem tempting for the Fed to wait for more data, history suggests that timely intervention is the key to achieving the coveted soft landing. By acting now, the Fed can support employment and price stability, ensuring that the US economy remains on solid footing as it heads into the future.
