Despite persistently high inflation lately and a robust economy and labor market, the Federal Reserve is expected to cut interest rates for the third time in a row this week.
What gives?
Some economists say Fed officials could make a blunder, risking reigniting inflation and undermining their pledge to rely on the latest data when making interest rate decisions.
“I think a rate cut next week will prove to be a mistake because (a) it is not justified and could backfire and fuel more inflation, and (b) it risks damaging the Fed’s credibility ,” said Bernard Baumohl, chief economist at the US Federal Reserve. Economic Outlook Group, wrote in a letter to clients.
However, others say that despite the worrying data, there are indications that inflation is still heading downward and that the Fed should stay on course to gradually return rates to normal levels.
The Fed is raising rates to reduce inflation by making borrowing more expensive and cooling the economy. It cuts interest rates to boost a weak economy and labor market or moves interest rates closer to a “neutral” level – which neither stimulates nor inhibits growth – as inflation declines. Interest rate cuts also tend to depress stocks.
Futures markets say there is a 97% chance the Fed will cut its key short-term rate by another quarter of a percentage point on Wednesday after a two-day meeting, but will pause in January and slow the pace of cuts to just two quarter points next year. That would be half of the four cuts Fed officials forecast in September. And it is consistent with officials’ recent comments about delaying the cuts through 2025 to assess their effects, especially now that the economy is on solid footing.
In 2022 and 2023, the central bank raised its policy rate from near zero to a range of 5.25% to 5.5% to quell a pandemic-related price spike that pushed annual inflation to a 40-year high of 9. 1% boosted.
Inflation has fallen below 3% this year, close to the Fed’s 2% target, prompting officials to cut rates by three-quarters of a percentage point since September.
But average price gains have remained high in recent months. In November, headline inflation rose for the second month in a row to 2.7%, based on the consumer price index, the Labor Ministry said last week. And core prices – which exclude volatile food and energy products that the Fed is closely watching – rose sharply for the fourth month in a row, keeping annual core inflation at 3.3% for the third month.
These core price changes are more sustainable because they are influenced by consumer demand, which the Fed can control with interest rates, rather than global commodity prices.
Wholesale costs, which typically influence consumer prices, also rose a hefty 0.4% last month, although much of that was due to a bird flu-related increase in egg prices.
Meanwhile, the economy has remained resilient despite high prices and interest rates that have hit lower-income households in particular. In the third quarter, the economy grew at a healthy 2.8% annual rate, and the Federal Reserve Bank of Atlanta forecasts a 3.3% increase in the current quarter.
And job growth rebounded sharply in November after hurricanes and strikes suppressed the previous month’s payroll totals, up 227,000.
In a recent speech, Fed Governor Christopher Waller said he was leaning towards a rate cut in December, but the Fed’s decision would depend on upcoming reports. These reports, which have now been released, show that inflation and the labor market have been hotter than expected.
So why is the Fed still planning to cut rates this week?
Fed officials have said the policy rate is too high and they are trying to slowly bring it down to a neutral level of around 3%. The rate is now 4.5% to 4.75%.
In his speech, Waller said the tariff is still “significantly restrictive” given the decline in price increases to date, meaning it could unnecessarily restrict the economy. “Mowing again,” he added, “just means we don’t press the brake pedal as hard.”
Barclays economist Marc Giannoni said the Fed would like to move rates closer to neutral as quickly as possible so that the economy is not further hampered and potentially threaten a recession. Then in January, after an overall rate cut of one percentage point, officials may pause to assess its impact, he said.
Fed Chairman Jerome Powell “may want to make another quarter-point cut before” President-elect Trump starts making good on threats to impose tariffs on imports from Canada, Mexico and China once he enters his first day in office. to intensify inflation, Baumohl said. Rates could force the Fed to hold rates steady or cut them more slowly than planned.
However, Powell has said officials are not yet factoring Trump’s uncertain trade policies into their decisions. Giannoni expects rates to increase inflation, but only in the second half of the year.
While overall inflation has increased, the details are more encouraging for Fed officials looking for a pullback.
Rents, which are the biggest contributor to inflation, rose by just 0.2% in November, the smallest monthly increase since July 2021.
Other persistent inflation factors, such as car repairs and car insurance, also rose modestly in November. The pullback in services inflation “should provide much comfort to the Fed overall,” chief national economist Kathy Bostjancic wrote to clients.
At the same time, items whose prices have soared in the past month and fueled inflation, such as hotel prices and cars, are volatile, said Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics. In other words, they will probably cool down quickly enough. New and used car prices were depressed by a burst in demand after two hurricanes in the Southeast damaged thousands of vehicles in early fall, forcing owners to replace them, Tombs said.
While the consumer price index has risen sharply recently, another inflation gauge that the Fed tracks more closely — called the personal consumption expenditures index — is expected to show smaller cost increases.
A report next week is likely to show that the PCE index rose just 0.1% month-on-month in November, Barclays said. Items such as vehicles and hotel rates that weigh heavily in the CPI contribute much less to the PCE measure, Tombs said.
Although job growth is solid, the labor market is cooling. The unemployment rate rose from 4.1% to 4.2% last month, Barclays noted. And average annual wage growth remained stable at 4%, down from 5.9% at the start of 2022. Strong growth in productivity – or output per employee – should allow companies to make large wage increases without incurring higher costs through price increases to be charged to the consumer, according to Oxford Economics.
On Wednesday, Fed officials are expected to forecast only two or three rate cuts next year, Barclays said.
Because such forecasts can influence the public’s inflation expectations, which can also influence inflation itself, estimates of fewer cuts would send a more cautious signal and partially offset the effects of a rate cut, Giannoni said.
Futures markets that bet on Fed rate moves, along with the stock market, think a rate cut on Wednesday is all but certain. If last week’s inflation numbers left officials reeling, they had no chance to get that message across to the public.
While Fed officials formally insist that markets not influence their decisions, economists say the central bank is reluctant to upset them. “They don’t want to push back market expectations,” Giannoni said.
This article originally appeared on USA TODAY: The Fed will cut rates again despite rising inflation. This is why.
