Interest Rates: What The Fed Is Thinking

Image Source: Depositphotos Inflation has come down, but the Federal Reserve has left interest rates at their high levels. That has led many to wonder, “What are they thinking?” For people in real estate and others who are highly impacted by interest rates, the question is often punctuated with puzzlement or profanity.The Fed’s policy-making committee members continue to emphasize a few points: their goals, the importance for low and steady inflation, the long time lags in monetary policy, and uncertainty surrounding the economic forecast. Putting these elements together help to understand where interest rates will go in the coming years.

The Federal Reserve’s Goals And The Economy
The Fed’s goals are captured in the “dual mandate,” derived from the law that established the Federal Reserve System. The two goals are low inflation and maximum employment.In looking at employment, the Fed now takes a long-term view. They believe that low unemployment is best achieved by keeping inflation low and steady. In decades past, the Fed looked at short-term tradeoffs: tolerating a little more inflation would reduce the unemployment rate in a few months. Now, however, the Fed believes that tolerating higher inflation leads to economic instability, more pronounced business cycles, and perhaps even lower long-term economic growth. So they think about employment over many years, not just this month or quarter.The Fed also believes that monetary policy—changing interest rates and the Fed’s balance sheet—operates with long time lags. Statistical analysis suggests that Fed policy’s impact on employment comes long after the actual change in interest rates. That means they cannot simply adjust interest rates based on current conditions.

Interest Rates And The Current Economy
With that framework, the Fed’s policy-making committee looked at current economic conditions. Inflation has come down a great deal. Using their preferred measure, inflation peaked at seven percent and has come down to just 2.7 percent. The target is 2.0 percent.Employment has increased every month this year, but we have some small indicators of softening. Job openings have decreased, and voluntary quits have also dropped. Fewer people are quitting their jobs because they realize there are fewer jobs available to move to.

The Argument For Cutting Interest Rates
An argument for cutting rates now could well be made, based on two observations. First, the data on both inflation falling and employment dropping will be reinforced by the time lags of cause-and-effect. Past interest rates will slow the economy for months to come even if interest rates are cut today.Second, those time lags mean that the Fed cannot wait until unemployment is a problem—by then it will be too late. The Fed must set policy not for where the economy is today, but for where it will be next year.

Why The Fed Did Not Cut Interest Rates
But the arguments for cutting interest rates did not fly at the Fed’s June meeting. Two reasons predominate. The Fed recognizes that their computer models of the economy have done a very poor job forecasting inflation. To be fair, everyone else’s models have also done poorly. That has led to Fed to a rare characteristic in Washington, DC: humility. The Fed puts little stock in its own forecasts of inflation, so they are not at all sure that inflation has been beaten, or will be beaten anytime soon.The second reason for standing pat right now is the Fed’s “risk management” perspective. Like business leaders across the country, when the Fed has to make a decision under uncertainty, they estimate the cost of being wrong in one direction and the cost of being wrong in the other direction. If they keep interest rates too high for too long, they believe the cost will be higher unemployment temporarily. But if they cut interest rates too soon, then people will expect more inflation. People in their roles as consumers, workers and business leaders will embed inflation expectations in their decisions. That will make bringing inflation down eventually more costly, including higher unemployment.

The Forecast For Interest Rates In 2024 And 2025
The Fed’s view of its goals, of how inflation and employment interact, and how monetary policy affects the economy, will lead to continued caution. Some improvement in inflation will very likely arrive, so they will cut interest rates. But they will do so gradually and cautiously.My forecast is for two cuts of a quarter percentage point each this year, with three more next year. But given the uncertainties, business leaders should probably stick with words rather than numbers: “gradually and cautiously.” (The particular interest rate they operate on is the Federal Funds rate, a short-term measure.)More By This Author:Housing Forecast 2024 And 2025: Little BetterThe Gold Rally Of 2024: Sanctions Make Forecasts HardImmigration Helps The U.S. Economic Forecast, Says One Data Set