The Federal Reserve Should Have Cut Interest Rates on January 31, 2024...

Somewhat alarmed at the Federal Reserve's standing pat on January 31, 2024A first draft of a column for Project Syndicate; the economy appears to be at cruising speed: full employment, low...

Somewhat alarmed at the Federal Reserve's standing pat on January 31, 2024A first draft of a column for Project Syndicate; the economy appears to be at cruising speed: full employment, low inflation, and in neutral as far as private-sector shocks are concerned. So why isn’t policy in or rapidly moving towards neutral?...

---

The Federal Reserve stood pat on January 31:

Federal Reserve: Statement: January 31, 2024: ‘Federal Reserve issues FOMC statement: For release at 2:00 p.m. EST: Recent indicators suggest that economic activity has been expanding at a solid pace. Job gains have moderated since early last year but remain strong, and the unemployment rate has remained low. Inflation has eased over the past year but remains elevated.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. The Committee judges that the risks to achieving its employment and inflation goals are moving into better balance. The economic outlook is uncertain, and the Committee remains highly attentive to inflation risks.

In support of its goals, the Committee decided to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 percent. In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans. The Committee is strongly committed to returning inflation to its 2 percent objective.

In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on labor market conditions, inflation pressures and inflation expectations, and financial and international developments.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Thomas I. Barkin; Michael S. Barr; Raphael W. Bostic; Michelle W. Bowman; Lisa D. Cook; Mary C. Daly; Philip N. Jefferson; Adriana D. Kugler; Loretta J. Mester; and Christopher J. Waller. <https://www.federalreserve.gov/newsevents/pressreleases/monetary20240131a.htm>

I focus on “decided to maintain the target range for the federal funds rate at [its current] 5-1/4 to 5-1/2 percent...” and on how the FOMC “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent...”

This announcement has left me somewhat alarmed: the economy appears to be at cruising speed: full employment, low inflation, and in neutral as far as private-sector shocks are concerned; so why aren’t the policy levers in or rapidly moving towards neutral as well?

Consider the current state of the economy:

The U.S. macroeconomy right now is moving forward at sustainable cruising speed. It is in balance. It has a full employment-level unemployment rate of 3.7%. It has an at-target past six months PCE-core inflation rate of 1.9% per annum. It appears to be not just in current balance but in neutral. I can see no significant private-sector forces at work working to imminently strengthen demand in a way that boosts inflation. I can see no significant private-sector forces at work working to imminently weaken demand in a way that would compel recession

And neither does anybody else.

Oh, there are still a few people who worry that the current somewhat-elevated state of the Beveridge Curve unemployment-vacancy relationship indicates the potential for growing wage-inflation pressures. But such worries require pretending that vacancy job postings in this digital era have the same meaning as in the past, when you had to spend money to post a vacancy, and then interview those who in response knocked on your door. The coming of the modern internet has made posting a vacancy essentially free for firms. It has also made rejecting an applicant trivial to accomplish, and—given the enormous magnitude of blasting out applications—not a negative signal that may impede making a firm-worker match in the future. With these changes, it would be astonishing if the modern Beveridge employment-vacancy relationship were at all the same as in previous cycles. And, indeed, those who have attempted to use an estimated slope for the Beveridge Curve as a forecasting tool have missed the mark massively in this episode.

And there may be some who think that it is a dangerous macroeconomic situation if real wages are ever noticeably rising. But margins cannot expand forever. The labor share cannot fall forever. We should, after the past generation, expect some shift back to workers and some degree of return of the labor share to what we used to think of as normal, as at least some of the factors that have boosted capital’s bargaining power ebb. Plus there is productivity: a high-pressure full-employment economy tends to be a high productivity-growth economy, as businesses find training workers and investing in boosting their productivity an attractive option relative to trying to dip into a shallower pool of potential hires. We saw this Wednesday morning, with the U.S. Bureau of Labor Statistics reporting a 3.2% per year productivity-growth fourth quarter of 2023, capping off a 2.7% increase in nonfarm-business productivity from the fourth quarter of 2022 to the fourth quarter of 2023 <https://www.bls.gov/news.release/prod2.nr0.htm>.

Neither the Beveridge Curve nor fear that real-wage increases herald an imminent rebound to inflation are foundations on which to base a forecast.

Lurking in the background there remains the risk asymmetry imposed by the existence of the zero lower bound on interest rates. The Federal Reserve always has the capability to raise interest rates. It cannot cut its policy rates below zero. This asymmetry imposes a strategic constraint on monetary policy: it is extremely unwise for the Federal Reserve to get itself into situations in which it might start contemplating reducing the policy rate to zero.

Plus there is the principal that in a balanced and neutral economy—like the current one—there is a very strong presumption is that policy should be neutral. A neutral monetary policy implies setting interest rates at their long-run neutral level, that shadowy and hidden mystery referred to as "r*" at which monetary policy is neither stimulative nor restrictive..

I do not think even a small handful of the members of the Federal Open Market Committee (FOMC) believe that today's r* corresponds to a policy rate in the range of the current 5.25% to 5.5%. Thus policy right now is presumed by nearly all participants in FOMC meetings to be not neutral, but restrictive..

And yet today's announcement carried a strong message that the FOMC is in no rush to align policy rates with the presumed value of the neutral rate r*.

This, I think, should be a matter of strong concern for us all. What is the thinking—about current inflation pressures, about the level of r*, about the likely distribution of future supply shocks, about the likely distribution of future demand shocks—that justifies hesitance in moving policy rates back to neutral?

When a boat is pointed at its destination, its tiller should be neutral. It should not be substantially over to the right.

---

References:

• Bok, Brandyn, & al. 2022. "Finding a Soft Landing along the Beveridge Curve." Federal Reserve Bank of San Francisco Economic Letter, August. <https://www.frbsf.org/economic-research/publications/economic-letter/2022/august/finding-soft-landing-along-beveridge-curve/>.

• Bureau of Labor Statistics. 2024. "Productivity and Costs." News Release. January 31. <https://www.bls.gov/news.release/prod2.nr0.htm>.

• Federal Reserve. 2024. "Federal Reserve issues FOMC statement." Federal Reserve, January 31. <https://www.federalreserve.gov/newsevents/pressreleases/monetary20240131a.htm>.