The Federal Reserve’s decision to cut interest rates last week has raised a lot of questions. The rhetoric accompanying the action suggests that this may be the last cut for a while, and it has prompted rare dissent among the Fed’s own policymakers and not a little public criticism as well. Unusually, stocks fell on the rate-cut news, and bond yields rose. Of greatest concern, however, is how the Fed’s recent actions and statements have created a new and unpleasant uncertainty about its intentions for the economy and for controlling inflation.
There were no such uncertainties last September, when, after hiking interest rates dramatically the prior two years, the Fed began cutting them. Back then, signs of economic weakness spoke to a need for policy easing—to avoid recession and to bring the economy in for a “soft landing.” At the same time, inflation was moderating nicely. It was still running a bit above the Fed’s target rate of 2 percent a year, but it had come down dramatically from the frightening levels of 2022. There was reason to believe that the lagged effects of the Fed’s past actions would keep inflation moving toward the preferred target range, allowing the Fed to supply the economy’s need for easier monetary policies going forward.
Since September, the picture has become more muddled. The economy seems to have regained strength and accordingly has less need for support. At the same time, inflation appears to have resisted the favorable glide path. Different measures offer different metrics, but all show figures stubbornly above the Fed’s target, and some reveal a modest inflationary acceleration from the lows of last spring. It has become harder to argue that past Fed restraint will tame the inflationary beast. Indeed, the University of Michigan’s survey of economic attitudes shows expectations that inflation will continue above the 2 percent target indefinitely. Both observations—on the economy and on inflation—suggest that the Fed may have moved prematurely toward policy easing in September.
Yet the central bank, without addressing these changed circumstances, cut interest rates in November and again in December. If Fed policymakers had reasons to worry about the economy, they failed to state them. If they had cause to believe that inflation, despite recent behavior, would moderate again, they failed to make that argument, too. On the contrary, the Fed’s own inflation forecast changed during this time to show higher, not lower, inflation in 2025 and a return to the target range only in 2027. Then, as if to make the Fed’s policy reasoning even less clear, Fed Chairman Jerome Powell suggested no more cuts for the time being. If renewed concerns over inflation led to the decision to stop easing policy in 2025, then it is reasonable to question why the Fed bothered cutting rates in December or even November. Powell has offered no explanations.
Financial markets clearly had serious questions about what the Fed was doing. Stocks, as measured by the popular S&P 500 Index, fell 3.2 percent immediately after the December interest rate cut. Usually, stocks rally on news of a drop in interest rates. The bond market has shown still more skepticism about what the Fed is up to. Instead of falling along with the rate cuts administered by the Fed, as is typical, longer bond yields have risen since the Fed began cutting interest rates in September. The yield on ten-year Treasury bonds has gained almost a full percentage point over this time, with much of that coming since the Fed’s December interest rate cut. Mortgage rates, too, have risen by nearly half a percentage point.
Dealers and investors have in these ways revealed at least two concerns. One is that inflation is far from tamed, and that the Fed accordingly will have to reverse its policy posture in 2025, raise interest rates, and possibly precipitate a recession. The second worry is still more ominous: that the Fed may have given up on the 2 percent inflation target and is ready to tolerate an ongoing rate of 3 percent. If that’s the case, then there is reason to fear still higher inflation rates. Even absent such a threat, a new, higher target would require a fundamental shift in the financial-economic environment, more investment caution, and less overall optimism about economic growth or stability. The worries themselves can become a self-fulfilling prophecy and accordingly do economic and financial harm, regardless of what the Fed is thinking.
The Fed could easily have avoided this rather dangerous confusion. Had it held interest rates steady in December and signaled less rate-cutting going forward, it would have announced that it has inflation concerns and will have to moderate the extent of its turn to easing. Had it cut interest rates in December and avoided the warning, it would have announced that the economy needed the support of monetary easing and that it was either sanguine about inflation returning to a moderate pace or willing, for the economy’s sake, to wait for more anti-inflationary action. Having cut rates and indicated less easing going forward, it has raised questions about its assessment of the situation and perhaps even its long-term intentions. In this way, the Fed has invited the destabilizing concerns that the market is clearly showing. Powell should clear up this confusion.
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