The Federal Reserve has said it is committed to reducing inflation from the June 2022 high of 9.1% back to under 2%. To do this, the Fed has aggressively raised interest rates, from mid-2022 and to mid-2023. Then, in July 2023, the Fed stopped the rate hikes. Now the Fed is cutting interest rates. The question is why?
The Federal Reserve’s monetary policy has three goals: Price Stability, Full Employment and Growth. Since it forgot about the first goal from January 2021 when inflation started to climb, to June 2022, it compensated with its aggressive rate hikes.
For some reason, it halted the rate hikes after July 2023. Although the inflation rate had fallen from the 9.1% peak to under 4%, the pause in interest rate increases allowed inflation to linger.
Instead of the inflation rate continuing its rapid decline, it stalled. The decline was helped by the weak worldwide demand for energy, which led to lower prices. Without the decline in energy prices, today’s inflation rate would be about 3.3%, certainly not near the Fed’s 2% target.
The Fed will respond to this criticism by noting it prefers to look at the Personal Consumption Expenditure (PCE) to gauge inflation. That number, which excludes the more volatile food and energy prices, is about 2.6%, which is still above the 2% target.
Besides, the PCE is not a true measure of price increases because it assumes the consumer will adjust buying patterns and purchase less of a good when the prices increase. That is true, but the PCE does not accurately measure the increase in prices.
The Fed says, since inflation has come way down, it can now concentrate on the second and third goals. That is full employment and growth. So, Fed officials argue, decreases in interest rates are warranted, because the economy is slowing, and it is not producing enough new jobs.
To avoid slower growth and higher unemployment, the Fed cut interest rates by 50 basis points in September, 25 basis points in November and is, perhaps, poised to cut another 25 basis points next month. This should add more demand to the economy to stimulate growth and create new jobs.
Federal Reserve Chairman Jerome Powell has made several serious and costly errors since his appointment in 2018. His first was raising interest rates for no reason in 2018, which slowed economic growth just as the 2018 tax cuts took effect. Then he kept interest rates near zero from January 2021 to June 2022 while inflation skyrocketed.
Then he paused the interest rate hikes in July 2023, which allowed inflation to linger. And now he is cutting interest rates. Why?
Ask any economist what level of unemployment is considered a full employment economy and they will say, 4%. Last July the unemployment rate was 4.3%. Then it dropped to 4.2% in August, 4.1% in September and 4.1% in October. We are at full employment now. There is no reason to drop interest rates, especially considering the fact that the decreased interest rates will add to the excess demand that is already driving inflation higher.
The economy grew at a 3% rate in the second quarter of this year and 3% in the third quarter. With strong retail sales and increasing consumer confidence, most economists are forecasting fourth quarter growth to be in the 2.5% to 3% range. Since this growth rate is healthy, and inflation continues to linger, interest rate reductions are not warranted.
Even though the Fed cut rates in September and again in November, the yields on Treasure bonds are increasing to the 4.5% range. Additionally, mortgage rates which should have fallen to the 5.5% range with the Fed cuts are hovering near 7%. The market is saying that the Fed should not be cutting interest rates at this time.
Admittedly, it is difficult for Americans to live with the high interest rates. Car sales are softening, and homes are much more expensive. Credit card interest rates are very high. Consumers would welcome the relief of lower interest rates.
So would business. The high borrowing costs have slowed some expansion plans and generally make doing business must more difficult.
Still, price stability must be the top priority, especially now when 2025 will mark the fifth year the country has had an inflation problem. This is very dangerous. If inflation continues to embed itself into the economy, it could take very strong future action to finally get inflation out of the economy.
The Fed must stop cutting interest rates at this time.
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Michael Busler is a public policy analyst and a professor of finance at Stockton University in Galloway, New Jersey, where he teaches undergraduate and graduate courses in finance and economics. He has written op-ed columns in major newspapers for more than 35 years.
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