The FOMC Should Not Lower Rates, Yet

The market is assigning high odds that the Federal Open Market Committee (FOMC) will lower its policy rate a quarter point on December 18, to 4.25 percent. A better choice would be for it to do nothing. Why? To begin, inflation is above the FOMC’s target rate of 2 percent. October CPI inflation was running at an annual rate 2.6 percent, and PCE inflation, the FOMC’s preferred inflation measure, was 2.3 percent. Core inflation, which excludes food and energy from the measure, was 3.3 percent and 2.8 percent, respectively. These numbers do not represent price stability. Unless tomorrow’s updated CPI numbers for November show a significant decline, the FOMC should wait to see where economic conditions are headed and what effect they might have on the longer run economic and inflation outlook before it acts. Some FOMC members have noted that the road to the 2 percent inflation target is bumpy; if so, the FOMC should ease up on its rate cuts until it knows better what the road ahead looks like.

Not only is inflation above target but the economy continues to grow above its long-run real GDP growth potential of closer to 2 percent. Real GDP growth for the third quarter was 2.8 percent, and the Atlanta Federal Reserve Bank’s estimate for real fourth quarter GDP growth is between 2.7 and 3.2 percent. November’s payroll employment increased by 227,000, showing renewed strength following October’s disappointing increase related to weather and labor strikes. November’s unemployment rate was 4.2 percent, still full employment, and real average hourly earnings increased at an annual rate of 1.4 percent. Consistent with this wage growth, retail sales appear to remain strong. For example, the National Retail Federation reports the number of Black Friday in-store shoppers exceeded 81.7 million and on-line shoppers exceeded 87.3 million, both were judged good numbers. While year-over-year housing investment for October declined, other fixed investment increased 3.5 percent, reflecting continued strong investment in technology and the stimulative effects of government support for green energy and infrastructure. These performance numbers do not suggest that policy is behind the curve or there is an immediate need to lower rates further.

While FOMC members are unanimous in their statements about achieving a 2 percent inflation target, they nearly always add that they are fully committed to full employment. Given this often-repeated emphasis on full employment, it appears the committee has made it a priority. Having set the priority, it has reduced its policy rate 75 basis points to 4.5 percent, which the Committee still considers restrictive or highly restrictive. But is it?

With the FOMC’s policy rate at 4.5 percent and the CPI at 2.6 percent, the real policy rate is around 1.9 percent. Even using the PCE inflation measure of 2.3 percent results in a real policy rate near 2.2 percent. Comparing estimates of real interest rates to recent estimates for the equilibrium rate of interest, what the FOMC refers to as r*, suggests that monetary policy is, at most, mildly restrictive. For example, in an article published by the Richmond Federal Reserve Bank, it noted that r* might be between 1.7 and 2.2 percent; thus, indicating policy was not necessarily restrictive.

Finally, while the immediate focus is on the FOMC’s interest rate policy, other factors are in play pushing the economy above trend and above potential growth. Annual federal government spending exceeds $6 trillion and annual deficits are close to $2 trillion. This is expansionary. The Federal Reserve’s balance sheet has grown from $4 trillion to $9 trillion, and still is above $7 trillion, which has accommodated the government’s spending binge. As a result, Americans are having to deal with persistent asset inflation and its distributional effects, which policy makers tend to ignore. The stock market keeps achieving new record-breaking highs, housing asset prices continue to new highs. Bitcoin trades at close to $100,000 per token. While this favors some, it disadvantages many. It reflects policy-induced asset bubbles, and we don’t have to look back very far to understand the danger these out of trend performances levels mean to future economic and financial stability. Yes, the market wants to see rates lowered so it can further enjoy the moment, but prudence suggests the FOMC should wait, observe, and better judge where things are likely to end before it accommodates the market crowd.