Peter Morici, an economist and emeritus business professor at the University of Maryland, wrote that the Fed is likely to cut the federal funds rate by another 25 basis points at its meeting on Wednesday. The bigger question for Fed watchers and investors is how much further interest rates can be cut. To answer that question, policymakers must first answer five key questions:
1. What is the state of the US job market? The US economy grew at an annual rate of 2.8%, much higher than the 1.8% projected by the Congressional Budget Office. At the same time, the US unemployment rate was 4.2%.
In the summer of 2023, the U.S. economy is at full employment by any measure, but it adds 191,000 jobs per month over the next 15 months, far more than the 80,000 that would be consistent with population growth and regular immigration. In addition to illegal immigrants seeking work, the U.S. economy needs 1 million to 1.5 million additional legal immigrants entering the labor force each year to maintain the current pace of economic growth.
Employee compensation is growing at 3.9% a year, which should be consistent with inflation of about 2% and productivity growth of 1.9%. At the same time, the unemployed are taking longer and having a harder time finding work, but cutting rates too much could overheat the labor market and push up inflation.
2. Have prices stabilized? The consumer price index (CPI) appears to be stagnant - the annual growth rate is about 2.7%, and 3.3% excluding food and energy. The overall inflation rate is stable at around 2.5%, which may be enough for the Fed. Housing costs and other non-energy service prices are up about 4.6% year-on-year.
Commodity prices have been falling, largely because of lower oil prices. However, with China's economic stimulus measures supporting growth, the Fed would be foolish to expect the glut in the oil market to continue indefinitely.
3. What impact have rate cuts had so far? The Fed's cut in the federal funds rate should theoretically reduce the 10-year Treasury yield and the commercial borrowing rate that is based on it.
Yet since the Fed began its rate-cutting cycle in mid-September, 10-year Treasury yields have been rising, not falling. Mortgage and corporate bond rates are also rising. Investors, it seems, are not convinced by the Fed’s confidence that inflation is trending toward 2%. Investors also apparently expect GDP growth to continue to be above historical norms—perhaps thanks to the large federal budget deficit and the expected boost to productivity from artificial intelligence.
Against this backdrop, if the Fed cuts rates too much, it would fuel skepticism in the bond market and overheat the investment boom sparked by AI.
4. Will the policies of President-elect Trump push up inflation? Trump's leadership could mean weakening the independence of the Federal Reserve, imposing tariffs, expelling job-seeking immigrants, and rolling back policies that promoted investment in semiconductors, green industries, and electric vehicles during the Biden administration.
Trump could increase border enforcement, deporting criminals and people with outstanding deportation orders. To make matters more confusing, he would face lawsuits. The Trump administration can expect many lawsuits from progressive opponents.
Given the millions of illegal immigrants in the country, limited regulation policies won’t cause serious inflation. But if Trump gets too heavy-handed, those policies will constrain the labor supply and stoke inflation, which would be a huge disaster.
5. What is the neutral real interest rate (r*) in the Goldilocks scenario? The Fed must strike a balance so that its policies do not stimulate too much demand and generate inflation, nor do they constrain productive investment and economic growth.
In its latest forecasts, the Fed set its long-run federal funds rate target at 2.9%. At a 2% inflation target, this means its policymakers estimate r* to be 0.9%. With the U.S. economy expected to grow much faster than before the pandemic, r* is likely to be closer to 1.5% to 2.0%.
With inflation hovering around 2.5%, that would put the appropriate target for the federal funds rate at 4.0% to 4.5%. The upper end of that range is already close to where the Fed was after it announced a rate cut this week.
As a real estate developer, Trump instinctively favors lower interest rates. However, if he fails to combine effective U.S. border enforcement with meaningful liberal immigration reform, inflation will rise again, and that would mean interest rates well above 4.5%.
Article forwarded from: Jinshi Data
