Why cut rates in such a strong economy? The Federal Reserve faces a big question.


The Federal Reserve is widely expected to leave interest rates unchanged at the conclusion of its meeting on Wednesday, but investors will be watching for any hint of when and how much it might lower those rates this year.

The expected rate cuts raise a big question: Why would central bankers reduce borrowing costs when the economy is experiencing surprisingly strong growth?

The U.S. economy grew 3.1 percent last year, up from less than 1 percent in 2022 and faster than the five-year average before the pandemic. Consumer spending in December came in faster than expected. And although hiring has slowed, the United States still has an unemployment rate of just 3.7 percent, a historically low level.

The data suggests that although the Federal Reserve has raised interest rates to a range of 5.25 to 5.5 percent, the highest level in more than two decades, the increase has not been enough to slow the economy. In fact, growth remains faster than the pace that many forecasters consider sustainable over the long term.

Federal Reserve officials themselves projected in December that they would make three rate cuts this year as inflation steadily cooled. However, lowering interest rates in such a strong environment might require some explaining. Typically, the Fed tries to keep the economy running in balance: lowering rates to stimulate borrowing and spending and speed things up when growth is weak, and raising them to cool growth and make sure demand doesn’t overheat. and increase inflation. .

The economic resilience has made Wall Street investors suspect that central bankers may wait longer to cut rates; They were previously betting heavily on a move lower in March, but now they see the odds are only 50-50. But, some economists said, there could be good reasons for the Federal Reserve to reduce borrowing costs even if the economy continues to advance.

Here are some tools to understand how the Federal Reserve plans its next steps.

The central bank will not release new economic projections at Wednesday’s meeting, but Jerome H. Powell, Chairman of the Federal Reserve, could offer details on the Fed’s thinking during his news conference after the 2 p.m. policy decision. .

One topic you will likely discuss is the all-important concept of “real” rates: interest rates after subtracting inflation.

Let’s analyze that. The Federal Reserve’s main rate is quoted in what economists call “nominal” terms. That means that when we say that interest rates are set today at around 5.3 percent, that figure doesn’t take into account how quickly prices are rising.

But many experts think what really matters for the economy is the level of interest rates after adjusting for inflation. After all, Investors and lenders take into account the future purchasing power of the interest they will earn when making decisions about whether to help expand a business or make a loan.

As price pressures cool, economically relevant real rates rise.

For example, if inflation is 4 percent and rates are set at 5.4 percent, actual rates are 1.4 percent. But if inflation falls to 2 percent and rates are set at 5.4 percent, real rates are 3.4 percent.

That could be key to Fed policy in 2024. Inflation has been slowing for months. That means that, although rates today are exactly where they were in July, they have been rising in inflation-adjusted terms, weighing more and more on the economy.

Rising real rates could put pressure on the economy just as it is showing early signs of moderation, and could even risk triggering a recession. Because the Federal Reserve wants to slow the economy enough to cool inflation without slowing it so much that it causes a slowdown, officials want to avoid overdoing it and simply sit still.

“Your goal now is to keep the landing soft,” said Julia Coronado, founder of MacroPolicy Perspectives. “So why risk tightening policy? “Now the challenge is to balance the risks.”

Another important tool for understanding this moment in Federal Reserve policy is what economists call the “neutral” interest rate.

It sounds strange, but the concept is simple: “Neutral” is the rate setting that keeps the economy growing at a healthy pace over time. If interest rates are above neutral, they are expected to affect growth. If rates are set below neutral, they are expected to stoke growth.

That dividing line is difficult to pin down in real time, but the Federal Reserve uses models based on past data to estimate it.

Right now, officials think the neutral rate is in the neighborhood of 2.5 percent. The federal funds rate hovers around 5.4 percent, well above the neutral level even after adjusting for inflation.

In short, interest rates are high enough that officials expect them to seriously impact the economy.

So why isn’t growth slowing more sharply?

It takes time for interest rates to take full effect, and those delays could be part of the answer. And the economy has slowed thanks to some important measures. The number of vacant positions, for example, has been steadily decreasing.

But with consumer spending and overall growth remaining strong, Fed officials are likely to remain cautious that rates are not weighing on the economy as much as they would have anticipated.

“The last thing they want to do here is declare mission accomplished,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. “I think they’re going to be very cautious about communicating this, and I think they have to be.”

The question is how the Federal Reserve will respond. So far, officials have suggested they are unwilling to completely ignore the rapid growth and want to avoid cutting rates too soon.

“Premature rate cuts could trigger a surge in demand that could initiate upward pressure on prices,” Raphael Bostic, president of the Federal Reserve Bank of Atlanta, said in a Jan. 18 speech.

At the same time, the current strong growth has occurred when productivity is improving: companies are producing more with fewer workers. That could allow the economy to continue expanding at a rapid pace without necessarily increasing inflation.

“The question is: can this be sustained?” said Blerina Uruci, chief U.S. economist at T. Rowe Price.

Uruci doesn’t think the strength of the economy will stop Federal Reserve officials from starting to cut rates this spring, although he thinks it will prompt them to try to keep their options open in the future.

“They have the advantage of not having to pre-commit,” Uruci said of the Fed. “They must proceed with caution.”

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