The most popular guessing game on Wall Street this year has been to ascertain when and by how much the Federal Reserve will cut interest rates. Shifting expectations surrounding a potential Fed pivot have caused wild market gyrations and overreactions.
Fed policymakers have not helped matters. They have repeatedly characterized their decisionmaking process as “data-dependent,” implying a backward-looking approach that is more reactive than proactive. Some have gone as far as to suggest that a data-dependent Fed is essentially an unsure one.
The Fed’s repeated failure to forecast price level changes accurately during the 2021 to 2022 inflation shock has dented confidence in its own ability to prognosticate. Yet there is risk in avoiding forward-looking monetary actions. Given the inherent lags associated with monetary policy, the Fed needs to formulate policy today based on expected future economic outcomes.
Belatedly recognizing the magnitude of the inflation shock, the Fed rapidly hiked policy rates between March 2022 and July 2023, intending to curb aggregate demand. Yet the U.S. economy remained surprisingly robust, with the unemployment rate staying below 4 percent for 27 consecutive months and counting.
Healthy labor market and strong household balance sheets have propelled and sustained U.S. consumer spending. Additionally, ongoing fiscal stimulus has not only softened but to some extent counterbalanced the impact of monetary tightening.
Inflation has declined markedly since its peak nearly two years ago in spite of robust demand. Disinflationary forces were primarily unleashed by supply-side developments, which included an easing of global supply chain bottlenecks, a massive surge in immigration, China’s exportation of its own goods deflation, and an uptick in labor productivity.
The normal channels through which Fed rate hikes are supposed to affect the demand-side of the economy were substantially muted this time around. Many households locked in ultra-low mortgage rates. Corporations were able to take advantage of historically low borrowing costs to term out their loans during 2020-21. These developments subdued the traditional interest-rate channel of the monetary transmission mechanism.
Furthermore, financial conditions remained relatively easy during much of the past two years. The Fed only directly controls short-term policy rates, which in turn rapidly affect money market rates. Longer-term borrowing costs and capital market conditions are only indirectly affected by central bank actions. Yield on long-dated Treasury securities, for instance, are presumed to be primarily influenced by expectations regarding the future path of short-term Treasury yields and by term premia (the extra amount paid to investors for lending their money over longer periods).
Benchmark 10-year T-note yield (which directly affects mortgage rates and corporate bond yields) rose by much less than the 525 basis point surge in policy rates, causing the yield curve to invert early and to stay inverted. Bond market participants have been repeatedly caught off-guard as they mistakenly kept betting on an early Fed pivot.
Inconsistent Fed messaging also bears some responsibility for the inadequate tightening of financial conditions. For instance, after long-term yields rose sharply and equity markets underwent a correction between July and October of 2023, the central bank prematurely brought forth an end to the brief tightening of financial conditions by signaling a dovish tilt.
A market rally ensued as financial analysts rushed to price in multiple rate cuts (at one point, as many as six or seven rate cuts were expected for 2024) and financial conditions eased sharply. Rapid recovery in equity markets since the October 2023 bottom has generated massive gains for asset holders and contributed to a positive wealth effect.
Data surprises during the first quarter of 2024 indicated that inflation had become sticky and that the last mile of the inflation battle might be a struggle. This caused markets once more to recalibrate expectations about rate cuts, forcing Fed officials into a policy U-turn.
Confusion surrounding the future path of short-term policy rates (partly a result of Fed’s data-dependent approach) has contributed to recent fluctuations in market rates. Additionally, the failure of the Fed to recognize and highlight underlying structural shifts in the post-pandemic era is causing persistent market mispricing of equilibrium rates and term premia.
Deglobalization and trade fragmentation, explosive growth in public debt, demographic shifts highlighted by a rapidly aging population, revival of labor’s bargaining power, expensive green transition to deal with climate change, and the AI-led investment spike are all factors that are likely to generate persistently higher neutral interest rates.
So, what can the Fed do? First, its summary of economic projections scheduled for release in June should indicate a higher and more realistic estimate of the neutral policy rate of 3.5 to 4.0 percent, rather than the current projection of 2.6 percent.
Second, given the distinct possibility that the current policy stance may not be restrictive enough to reach the inflation target anytime soon, the Fed should explicitly state that it will be comfortable with inflation that is within a range around its 2 percent inflation target (say, in the 1.5-to-2.5 percent range). This would free up the Fed to initiate a few “insurance” rate cuts this year, to limit downside economic risks.
Although modest rate cuts in the coming months will boost the odds of a soft landing, the Fed still needs to curtail financial market exuberance and remain vigilant on the inflation front. The Fed therefore needs to project a shallow easing cycle and signal a higher estimate for the long-term neutral rate.
Vivekanand Jayakumar is associate professor of economics at the University of Tampa.