WASHINGTON — As inflation moves closer to the Federal Reserve's 2% target, its policymakers are confronted with—and in some cases fueling—the hope that they will make a decisive policy shift next year and cut interest rates, possibly as early as in the spring.
Such a move would lower borrowing costs across the economy, making mortgages, car loans and business loans cheaper. Share prices could also rise, although share prices have already risen in anticipation of cuts, potentially limiting further gains.
However, Fed Chairman Jerome Powell recently downplayed the idea that rate cuts are imminent. With the central bank set to leave its key short-term interest rate unchanged at this week's meeting, Powell has not yet signaled that the Fed is finally done with its rate hikes. Recently at Spelman College in Atlanta, the Fed chairman warned that “it would be premature to conclude with confidence” that the Fed has raised rates high enough to completely beat inflation.
But the Fed's two-day meeting, which ends Wednesday, will mark the third straight time its officials have kept their policy rates unchanged, adding weight to the widespread assumption that the rate hikes are over.
After all, the economy is moving in the direction the Fed wants: On Tuesday, when the government releases the November inflation report, it is expected to show that the annual increase in consumer prices has slowed to 3.1%, according to a survey of economists from FactSet. sharply down from a peak of 9.1% in June 2022.
And vacancies have fallen, meaning companies are less desperate for workers and feel less pressure to sharply raise wages, which can accelerate inflation. Consumers are still spending, albeit more modestly, and the economy is still growing.
Such trends suggest progress toward what economists call a “soft landing,” in which inflation reaches the Fed's 2% target without triggering a recession. Analysts are increasingly encouraged by what they say is an unusually smooth adjustment to lower inflation.
That brighter outlook represents a shift in thinking. Last year, many economists had emphasized that beating inflation would require a sharp recession and high unemployment. In fact, falling inflation without an associated recession or job losses is “historically unprecedented,” economists at Goldman Sachs wrote in a recent note.
Austan Goolsbee, president of the Federal Reserve Bank of Chicago, said in an interview with The Associated Press last month that the United States is on track for the fastest annual decline in inflation on record this year. If so, Goolsbee says, the result could be a “bigger soft landing than conventional wisdom ever thought possible.”
That said, a soft landing is hardly assured. For example, if the Fed were to miscalculate and keep interest rates too high for too long, it could ultimately derail the economy and push it into a recession.
“There is more risk of a recession at these interest rates than of a renewed acceleration of inflation,” said Julia Coronado, president of MarcoPolicy Perspectives, an economic research firm. “So ultimately the next step will probably be a cutback.”
The timing of any interest rate cuts will depend on the health of the economy. A recession – or the threat of one – would likely prompt more and earlier rate cuts by the Fed.
Still, Friday's November jobs report showed companies are still adding jobs at a healthy pace, and the unemployment rate fell from 3.9% to a low 3.7%. Such figures suggested that the most anticipated recession in decades is not imminent. Investors have since lowered their expectations for the Fed's first rate cut from March to May.
The Fed could cut rates this year even if the economy continues to grow, as long as inflation continues to fall. A steady slowdown in price increases would cause inflation-adjusted interest rates to rise, pushing borrowing costs higher than the Fed plans. Lowering rates in this scenario would simply prevent inflation-adjusted borrowing costs from rising.
Still, economists say rate cuts in response to lower inflation could take longer than Wall Street expects, as the Fed wants to make sure inflation is under control before making such a move.
Jim Bullard, former president of the Federal Reserve Bank of St. Louis and now dean of Purdue University's business school, said that while he thinks the Fed is on track for a soft landing, policymakers should be cautious about rate cuts.
“I don't think you want to be too early with that because if you start the process of lowering the policy rate and then inflation goes back up, I think that could cause a lot of problems,” Bullard said. Such premature cuts are attributed to the Fed's failure to curb inflation in the 1970s.
And if job growth and economic growth remain healthy, rate cuts may not be necessary anytime soon, Bullard added.
“Why lower the policy rate if the real economy is doing fine?” he asked. “You might as well sit back and enjoy the disinflation.”
In any case, when the Fed releases its quarterly economic forecasts on Wednesday, it will include a forecast of where its policymakers think their policy rates will be at the end of 2024. Coronado expects that only two rate cuts will be implemented – half the number that financial rate cuts deliver. markets now expect.
If the Fed cuts rates twice in 2024, the first might not happen until the fall. Nancy Vanden Houten, chief U.S. economist at Oxford Economics, said her firm doesn't expect the first rate cut until the third quarter of the year.
“The Fed will want to see some more progress before considering rate cuts,” she said. “In our opinion, the financial markets have gotten quite ahead of themselves. We think the rate hikes are behind us, but it will be many months before the Fed starts cutting rates.”