FED will still fall behind the curve?

With both the jobs and inflation softening, the FED chose to lower its key overnight borrowing rate by a half percentage point, or 50 basis points, affirming market expectations that had recently shifted from an outlook for a cut half that size.

This decision of the FED lowered the federal funds rate to a range between 4.75%-5%. While the rate sets short-term borrowing costs for banks, it spills over into multiple consumer products such as mortgages, auto loans, and credit cards.

Clearly the FED cut rates 50-bps when it believes that the US economy is likely to experience a sharp downturn that jeopardises the full-employment target. It seems that the FED has put less faith in forecasts since its 2020 shift in policy framework under the leadership of former vice chair Richard Clarida. We saw this in action during the tightening cycle, for rather than anticipate the 2021/22 inflation surge with rate hikes, as many other central banks started to do, the Fed waited and only started to hike once inflation had become very elevated.

Now this might have looked a dangerous tactic at the time. Indeed, the FED came in for a lot of criticism at the time for being ‘behind the curve’. However, in the Standard Bank’s view, this episode revealed two things.

The first is that, even if you are ‘slow’ to hike rates the first time, it is easy to catch up. This is exactly what the Fed did. It shows that even 50-bps rate today also leaves the Fed behind the curve, it can (and probably will) catch up with aggressive easing in the future if it needs to.

The second point from the rate-hike cycle in 2022/23 is that, even if you do start slow and fall behind the curve, the maintenance of longer-term inflation expectations at around the target level can mean that price pressures normalise quickly.

In other words, there is a sense here that if the Fed has good anti-inflation credibility with markets and the public, it can afford to base policy on the actual development of data, like the labour market right now, and not have to base decisions on speculation about the future. It can do this safe in the knowledge that, if it has miscalculated and acted too slowly, the existence of stable long-term inflation expectations will help correct any inflation overshoot on the upside or the downside of the target.

Of course, if the Fed keeps miscalculating and keeps falling behind the curve, there is a risk that inflation expectations de-anchor from the Fed’s 2% target. If that happens, the Fed might have to be a bit more farsighted in the future in order to get ahead of the curve with its rate changes and try to wrest back some anti-inflation credibility. But, from what we’ve seen recently, even in the shape of the recent massive rise in inflation, the Fed is not in such a quandary right now.

For while it might prove the case in the future that this was too late, the Fed has plenty of time to catch up, and the Standard Bank doubts that this catch-up process will come at a big cost, just as its catch-up in the tightening cycle did not fracture the economy or financial markets.