The past three months of economic data offer an increasingly clear picture to Federal Reserve policymakers wrestling with the moment to begin cutting interest rates. The next meeting to consider rate cuts occurs July 30 and 31. It is possible the Fed will cut rates at that meeting. Instead, it might hold rates constant until the September 17-18 meeting.
I prefer a July rate cut, with a couple caveats.
The Federal Reserve is tasked with controlling the supply of money by setting borrowing rates for banks and buying or selling government debt. By lowering borrowing rates and purchasing government debt, it increases the money supply. This causes a short-term increase in economic activity as businesses and consumers sense increased demand for goods.
The Fed slows short-term economic activity by raising rates and selling government bonds. This causes businesses to pay more for capital and consumers to pay more for borrowing to buy cars and homes. These changes to money supply really only affect the short run. You cannot make the economy grow over the long run by changing the money supply.
Getting all this right is devilishly hard, if not impossible.
The Fed has about 600 economists studying national and local economies. They read studies, convene conferences and solicit economic advice from a variety of sources. They also collect comments from local business leaders, who might have a better handle on up-to-date changes on local conditions than economists looking at data that are weeks or months old.
The Fed also runs more than a dozen forecasting models and watches dozens of other models run by economists around the country. It creates and monitors new data sources, like the Atlanta Fed’s “GDP Now,” which is a constantly updated estimate of the nation’s gross domestic product. The Fed also monitors frequently updated data products, like the Sahm Rule (see https://fred.stlouisfed.org/release?rid=456) for recessions or the University of Michigan’s Consumer Sentiment Survey (see https://fred.stlouisfed.org/series/UMCSENT).
All this work is done transparently, with formal public statements (see https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm). Fed economists speak publicly about their models, publish them in journals and often move in and out of universities.
The Fed sees what the rest of us see, but with 600-plus sets of eyes all over the country. So, what are they seeing?
First, Fed economists are looking at inflation. The whole of their efforts for more than two years have been to restrain inflation enough that we don’t plunge the economy into recession. What they’re now seeing is inflation slow dramatically. As of the June release, the U.S. actually slipped slightly into the deflationary range with the Fed’s preferred measure of inflation.
Over the past three months, the average annual growth rate is at 2.4%, or just inside the targeted rate of 2.0% to 2.5%. There are several reasons for this target. First, if inflation is pushed too low, the economy will slow too much and we could slip into a recession. So, it is better to accommodate some modest inflation.
The Fed also knows that measuring inflation isn’t a perfect business. In particular, it is difficult to include quality improvements in products in the inflation measure. Deflation is far riskier than inflation, so it is important to remain safely above zero.
There will be one more measure of Personal Consumption Expenditure data released before the July Fed meeting. If it is low, or even modestly negative like it was last month, that will at least trigger the Fed to say it expects to cut rates in September. If it is high, say above 2.5 %, we should expect them to hold off on rate cuts past their September meeting.
The Fed also looks at economic growth, which has been sustained but slowing in recent months. Labor markets have remained strong, with American businesses creating between 160,000 and 310,000 jobs per month for the past year.
GDP growth also has been surprisingly strong over the past year. The U.S. is clearly outpacing other developed nations in the value of goods and services we produce. The Fed’s forecast is for us to end 2024 with 2.1% GDP growth in 2024 (inflation adjusted), dropping to 2% in 2025. By comparison, the economy in 2017-2020 grew at an average annual rate of 1.8%.
This strong economic growth permits the Fed to delay reducing interest rates until it is more certain about inflation. Remember, the senior Fed economists are mostly in their 50s and 60s and attended graduate school in the 1980s. At the time, inflation had plagued the U.S. economy for two decades. In 1990, the Consumer Price Index had only been under 2.5% for a few months in 20 years. Throughout the 1980s, it averaged 6.4% as compared to 4.4% since COVID-19.
Fed economists are rightly concerned with inflation. With unemployment rates at more than 50-year lows, there’s little in the macroeconomic data to suggest risk of a recession. It is difficult to find real data that indicates economic or financial stress in the country.
Delinquency rates on credit card loans sit at 3.16%, well below the 30-year average of 3.73%. Mortgage delinquency rates are at 1.71%, a low point since the summer of 2006. Household debt payments, as a share of family disposable personal income, is lower now than at any time from 1980 to COVID. Wages are up more than 4.08% from this time last year, while inflation is up 3.25%.
In other words, all the talk of a crashing, risk-filled economy where people are struggling is unsupported by actual data. The adults at the Fed are worried about data.
However, the strong performance of the domestic economy is not an absolute brake on the Fed lowering interest rates. In fact, several prominent economists, including Claudia Sahm, have argued the risk to inflation of cutting rates is very modest. Rather, the risk to further weakening labor markets when inflation is now so modest should be the Fed’s focus.
I agree.
Absent a hot inflation report in late July, the Fed should cut rates a quarter point at its July 30-31 meeting. It should also make clear it is unlikely to cut rates in September. A modest reduction in interest rates would signal that we have entered a period of declining borrowing costs. I haven’t seen a single study or heard a single economist suggest that such a modest cut would endanger the fight against inflation.
This action would also signal we are firmly in soft landing territory, in what was probably the most effective Fed intervention in history.
Michael J. Hicks is the director of the Center for Business and Economic Research and the George and Frances Ball Distinguished Professor of Economics in the Miller College of Business at Ball State University. Send comments to [email protected].
