The Big Picture

The Federal Reserve's most recent tightening cycle began in March 2022 or 26 months ago. There are various views on the subject, but it has been theorized that it can take anywhere from 6-18 months for a single rate hike to have a slowing effect on the economy. The opposite holds true for a rate cut.

The timing is quite unpredictable, which is why it is said there are long and variable lags with monetary policy. That understanding is why economists and market watchers are on heightened alert for recessions signals. The latest tightening cycle has included 11 rate hikes, and while the bar for another rate hike is high, the specter of another rate hike has not been vanquished from the market.

Nonetheless, most Fed officials are allowing for the possibility that the Fed could cut rates before the end of the year. That is the Fed's base case anyway in the Summary of Economic Projections (SEP), which in March showed a median estimate for three rate cuts in 2024.

That might be whittled down to two rate cuts, or perhaps only one, when the updated SEP is released June 12. After all, the fed funds futures market is only pricing in one rate cut before the end of the year -- a far cry from the five or six rate cuts it envisioned coming into the year.

That view changed dramatically for two reasons: inflation hasn't changed dramatically and neither has the economy. Both have been resilient, which is good in the case of the economy, but not so much in the case of inflation.

Of course, that has created questions about whether the Fed's policy is tight enough at the same time there are worries, because policy operates with a long and variable lag, that the Fed has tightened too much.

The Goldilocks Rate

It is interesting that there has been a lot of attention paid to r*, which Fed Governor Waller described in an insightful speech this week as the "real policy interest rate that is neither stimulating nor restricting economic activity with inflation anchored at the central bank's inflation target."

Call it the Goldilocks rate: not too hot, not too cold, but just right.

This is the fundamental question right now. Is the Fed's policy rate just right?  Does it have r* where it needs to be?

What you'll hear from Fed officials is that they aren't entirely sure. They think they're in the right ballpark, however, since inflation has been coming down and a tight labor market has been showing signs of loosening. Still, the core-PCE inflation rate of 2.8% remains well above the 2% target and the 3.9% unemployment rate remains close to a 50-year low.

Atlanta Fed President Raphael Bostic, an FOMC voter in 2024, told students at Stanford's Graduate School of Business, according to Bloomberg, that, "The sensitivity to [the Fed's] policy rate -- the constraint and the degree of constraint that we're going to put on is going to be a lot less" because so many people and businesses locked in low-rate debt knowing the Fed would be raising rates to get inflation under control. That makes them less rate sensitive and mitigates the impact of the Fed's tightening cycle.

That is partly why the economy has been more resilient than many expected it to be in the wake of 11 rate hikes. Another factor that can't be dismissed is the enduring wealth effect that has flowed from rising home values for homeowners and rising stock prices, which are at a record high, for investors.

Then, of course, there was one element that certainly made things different this time: approximately $6 trillion of fiscal stimulus provided in response to the Covid pandemic, the bid to modernize U.S. infrastructure, and to make U.S. companies, particularly semiconductor companies, less reliant on foreign sources of production.

That played a major role in helping to stoke inflation, and it is presumably playing a role now in keeping inflation sticky above the Fed's 2% target.

A Different Starting Point

It has been argued by us, and others, that the Fed waited far too long to start raising rates. The Fed has even conceded that point, knowing that the delay forced it to be quite aggressive with its rate hikes.

The table below shows where inflation, the unemployment rate, and GDP stood at the time of the first rate hike in the Fed's last four tightening campaigns, including the current one.

Notably, core-PCE inflation was much higher and the unemployment rate much lower in 2022 than when other tightening campaigns began. Economic activity, on the other hand, was much weaker, but it wasn't long before consumer spending and business spending ramped up. GDP growth hit 2.7% in the third quarter of 2022, and it skied to 4.9% in the third quarter of 2023.

In other words, economic activity accelerated in the midst of the Fed raising rates 11 times. With GDP growth up just 1.6% in the first quarter of 2024, one might think the long and variable lags on growth are starting to hit home -- until one hears the Atlanta Fed GDPNow model estimate for real GDP growth in the second quarter is 3.5%.

Not only is that model suggesting GDP growth will be above potential but it also suggests there will be an acceleration in economic activity.

It makes one question why the Fed would cut rates at all. The argument advanced by many is that there will be reports of ongoing disinflation in coming months with supply constraints improving and demand patterns weakening as the labor market softens.

All one can do is to watch the data -- which is all the Fed will be doing -- to see if it corroborates that argument.

What It All Means

High inflation is problematic, particularly for low-income and middle-income consumers. The Fed is dialed in to that point, which is why it is intent on getting inflation back to the 2% target.

The Fed is going to need more help from a slowing economy and specifically from a weakening labor market to get there. As it stands now, it appears the long and variable lags it has come to count on during prior tightening cycles are still mostly missing in economic action.

--Patrick J. O'Hare, Briefing.com