ORLANDO — If recent history is anything to go by, the Federal Reserve will not wait for inflation to fall to its target before cutting interest rates again.
There is a growing chorus among investors that the Fed will not – indeed, cannot – cut interest rates this year because inflation is likely to run much hotter than the central bank’s 2% target through the end of 2023.
But a look at easing cycles since the early 1990s, when the 2% inflation goal first crystallized before being formalized in 2012, shows that the Fed has not hesitated in easing monetary policy even with inflation above target.
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Three of the most aggressive easing cycles – 1990-92, 2001 and 2007-08 – all started with inflation above 2%, even core rates which are usually lower and less volatile than headline.
This largely explains why interest rates futures markets doggedly expect up to half a percentage point of rate cuts later this year from a midyear peak, even though numerous Fed officials insist no easing is likely in 2023.
It is a curious standoff – rates traders are flat-out refusing to take the Fed at its word even though their long-standing mantra is “don’t fight the Fed.”
Their argument is you should watch what the Fed does rather than what it says.
But is this time different?
“That strategy fails when there is a regime change,” said Rebecca Patterson, former chief investment strategist at Bridgewater Associates, the world’s largest hedge fund. “And it feels reasonable to assume at least a significant probability that we are living through a regime change now.”
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TARGET IN SIGHT?
The Fed’s Open Market Committee delivers its latest policy decision on Feb. 1. A deceleration in the pace of tightening to 25 basis points, lifting the federal funds range to 4.50-4.75%, is expected.
The decision comes with annual inflation running between 4.4% and 6.5%, depending on the measure – headline or core, consumer price index (CPI) or personal consumption expenditures (PCE).
Headline and core PCE annual inflation rates in December were 5.0% and 4.4%, respectively. Headline and core CPI were 6.5% and 5.7%, respectively.
Inflation is coming down. A Reuters poll of economists has it back down to 2.6% by the end of the year, and inflation breakeven rates across the two- to 30-year maturity spectrum are not much above 2%.
The Fed itself sees inflation at 3.1% at the end of this year, 2.5% next year, and back at target by end-2025. The lagged effects of previous rate hikes have yet to be felt on the economy, however, potentially giving policymakers more leeway to ease over the coming year.
BLASTS FROM THE PAST
After the New Zealand central bank became the first to come up with the 2% target in 1989, the Fed began to adopt it informally. In the Alan Greenspan years, the inflation half of the Fed’s dual mandate was a de facto 2% goal for core PCE.
Under Chair Ben Bernanke in January 2012, the Fed formalized its annual inflation target: 2% PCE annual rate.
The Fed’s inflation target for 25-30 years, therefore, has been core or headline PCE of 2%, informally or formally, unwritten or written, unofficially or officially.
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But many rate-cutting episodes since 1990 came with PCE inflation above 2%, in some cases substantially higher. Here are three of the most prominent:
– Between July 1990 and September 1992, when the Fed cut interest rates to 3% from 8%, headline PCE peaked at 5.2% and bottomed out at 2.4%. Core PCE got as high as 4.4% before slowing to 2.7%.
– To counter the dotcom bust, the Fed slashed rates between January and December 2001 to 1.75% from 6%. The easing cycle started with headline and core PCE at 2.7% and 2.0%, respectively, before recession dragged both towards 1%.
– In September 2007 the Fed started easing policy to mitigate the U.S. housing crash and global credit crunch, with rates at 4.75%. It ended with rates at zero in December 2008.
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Easing started with headline PCE at 2.5%, rising to a 17-year high of 4.1% in July 2008 before tumbling; core PCE was 2.1%, rose to 2.4% in December 2007 and then crashed.
The situation today is clearly very different from all these periods and the Fed may not ease so aggressively. But if it does cut rates, inflation may well still be above 2%.
“The market is pricing close to 200bp of rate cuts between June 2023 and June 2025. Is it too much? Is it too soon? As long as the Fed brings inflation back to target, the answer to the first question is no. In that scenario, the Fed could cut ~350bp,” Deutsche Bank strategists wrote this week.
(The opinions expressed here are those of the author, a columnist for Reuters)
(By Jamie McGeever in Orlando, Fla. Editing by Matthew Lewis)
