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The Fed should resist the temptation to lower interest rates too soon

January 23, 2024
in Business
The Fed should resist the temptation to lower interest rates too soon
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The U.S. inflation news has been better lately, but the Federal Reserve should resist the temptation to lower interest rates too soon.

The economy has recovered well from COVID — GDP has returned to about where  economists expected it to be in early 2020 had the pandemic not occurred.

Labor force participation has recovered. It was 63.3% just before COVID and is now 62.5%. We could use the additional 2.1 million workers to relieve shortages, but the U.S. population is aging and women face additional childcare challenges with the return to offices.

The ratio of job openings to job seekers is about 1.4. and structural changes in the economy — the arrival of artificial intelligence, consumers buying more goods during pandemic shutdowns and now swinging back to services — have exacerbated labor shortages.

An analysis by former Fed Chairman Ben Bernanke and economist Olivier Blanchard indicates that ratio would have to fall to below 1.0 to get inflation down to 2%.

In December, the Consumer Price Index was up 3.4%, year-over-year. That’s better than the 9.1% in June 2022 and 6.5% a year prior. Much progress was accomplished through deflation for goods. China’s economic troubles, a cheaper yuan against the U.S. dollar and the depressed state of the oil market helped push down U.S. import prices.

China has fundamental strengths in electric vehicles, battery technology, solar panel and wind technology, lithium, rare earth minerals and other industries whose products Western economies and fast-growing Asian nations need. China will recover, and the yuan will stabilize. And as Europe pulls out of its latest funk, it will import more. All of this will end deflation for manufactured goods and commodities and raise petroleum demand and prices.

Meanwhile, a tight U.S. labor market and wage pressure remain influential in services, less energy, which constitute 59% of the CPI and where inflation scored at 5.3% in December 2023.

Shelter — which includes imputed rents on owner occupied houses, rental homes and apartment leases — accounts for 35% of the CPI and an even larger share of the index for core services. Private sector surveys indicate rents for new leases on apartments are falling. Most rental home and apartment leases adjust rent on an annual basis and some less frequently. Consequently, the impact of falling rents on new leases shows up in the CPI with a lag, and some analysts anticipate a big drag on the CPI in 2024.

But private rental indexes dropped a great deal from August 2022 to January 2023 without appreciably driving down the cost of shelter in the CPI in the months following.

In fact, most housing in America is owned, not rented. Housing prices rebounded in 2023 and are supporting imputed rent on owner occupied housing — that component is 73% of the shelter component in the CPI.

Construction costs for houses and new apartments are driven by ever-tighter local building regulations, which lengthen construction time, zoning issues, and labor and material shortages when housing construction goes through its periodic surges.

Monetary policy is becoming more lax

Economists anticipate U.S. economic growth will slow but not collapse into a recession in 2024, and recent good reports on inflation have markets and analysts anticipating the Fed will soon cut interest rates.

Indeed, in its most recent projections, the Fed penciled in the equivalent of  three, one-quarter point reductions in the overnight bank lending rate for 2024.

But cutting rates too soon would be a mistake.

Since October, the 10-year Treasury yield, which influences interest rates charged for mortgages and other credit throughout the economy, has declined below 4% because Treasury borrowing needs pulled back in last year’s fourth quarter and bond markets increasingly anticipated a rate cut.

In the current quarter, funding requirements will increase and without other changes in Fed policy, that should firm the 10-year Treasury yield around 4%, perhaps a bit higher. With core inflation at 3.9%, and assuming trend real GDP growth per Fed forecasts of 1.8%, a long-term Treasury rate of about 5.6% would be more appropriate. All this indicates the Fed’s current policy stance is hardly restrictive.

A recent IMF study of more than 100 inflation episodes across 56 countries since the 1970s  found that inflation was brought down to desired levels within five years in just 60% of cases. The biggest problem: premature celebrations — central banks cutting rates too soon.

When central banks stayed the course and accepted more short-term pain, inflation was more reliably controlled and GDP, employment and wages recovered well over a five-year horizon. The economy is likely to prosper more if the Fed finishes the job by getting core inflation to 2% before further pushing down interest rates.

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

More: Why the economy’s health right now isn’t as uncertain as you might think

Also read: Recession was inevitable, economists said. Here’s why they were wrong.

>>> Read full article>>>
Copyright for syndicated content belongs to the linked Source : MarketWatch – https://www.marketwatch.com/story/the-fed-should-resist-the-temptation-to-lower-interest-rates-too-soon-ee6f291c?mod=mw_rss_topstories

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