Greg Ip, chief economic commentator at The Wall Street Journal, said that given the current state of inflation and the labor market, there is a greater risk that the Federal Reserve will only cut interest rates by 25 basis points this month, and the central bank should cut interest rates by 50 basis points. Here are his views.
The Fed's rate decision this week looks much more difficult than it should be, but the real question is not how much it should be cut, but how low it should be. The answer is that it should be lower, which supports the view that a 50 basis point cut is in the cards.
Last summer, with underlying inflation well above 3% and the labor market overheating, the Fed was so concerned that inflation would remain high that it was willing to trigger a recession to prevent that from happening.
Fast forward to now, and some key underlying inflation measures are below 3%, with some even close to the Fed's 2% target. The labor market is not cold, but it is not hot either.
There aren’t many signs yet that a recession is imminent, but waiting for such evidence is risky.
A year ago, CPI inflation was 3.2%, and by August this year, it had fallen to 2.5%. During that period, the Fed's preferred core PCE rate fell from 4.2% to an estimated 2.7%.
The gap between 2.7% and the Fed's 2% target mainly reflects the lagged effects of housing, auto and other price increases a few years ago. Some alternative indexes try to exclude these special factors. Harvard University economist Jason Furman averages several indexes over different time periods to derive a single, PCE-equivalent underlying inflation rate. The figure was 2.2% in August, the lowest level since the beginning of 2021.
Inflation is likely to continue to fall. Oil prices have plunged from $83 a barrel in early July to below $70 last Friday. This will reduce overall inflation directly and indirectly reduce core inflation because oil is an input to almost every business. A study by Robert Minton, now at the Federal Reserve, and Brian Wheaton of UCLA found that oil explains 16% of the fluctuations in core inflation, and that 80% of the impact takes two years to show up.
Inflation-protected bonds and derivatives now expect CPI inflation to be 1.8% over the next year and 2.2% over the next five years, according to Intercontinental Exchange.
This is important in two ways. First, it means that investors are confident that the Fed will hit its 2% target. In fact, it suggests a risk that inflation could fall below target, a situation the Fed should not welcome. Second, as expected inflation has fallen, real short-term interest rates have risen to between 3.2% and 3.5%.
This is contractionary by any measure. Fed officials view the “neutral” real rate as 0.5% to 1.5%, at least 1.75 percentage points below current levels. In 2022, the Fed raised rates in 50 basis point and 75 basis point increments because its starting point was deeply negative real rates, which were far from neutral. The same logic should apply now, just in reverse.
Meanwhile, the labor market is cooling rapidly. The rise in the unemployment rate from 3.5% in July 2023 to 4.3% a year later sparked panic because in the past, such an increase would have meant the U.S. was in a recession. It was a false alarm. Consumer spending, unemployment insurance claims or U.S. stocks showed no signs of trouble in the economy, and the unemployment rate fell slightly to 4.2% in August. However, the data did not give any inflationary pressures to worry about.
The Fed always runs the risk of doing too much or too little. The question is, which is worse? A 50 basis point rate cut is not without risk. Long-term Treasury yields could fall further, pulling down mortgage rates. Stocks could become frothy.
Inflation could also prove more stubborn or even rise further, especially if oil prices rebound or tariffs are raised. If that happens, the response should be clear: no more rate cuts, and interest rates will remain high.
However, a 25 basis point rate cut looks riskier. One reason crude oil and other commodities like copper are falling is that the global economy doesn't look healthy. Rising auto loan and credit card delinquencies suggest higher rates are having an impact. The yield curve inverts because the market thinks rates should be lower.
The Fed already tends to move slowly. In hindsight, given weak employment and tame inflation data, the Fed should have cut rates in July. If the Fed only cuts by 25 basis points now and more weak data arrives, it will be even further behind the curve.
The article is forwarded from: Jinshi Data