Robust recovery in employment figures for 2023
Last month, employers hired 216,000 new workers, 46,000 more hires than analysts and economists had forecast.
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As inflation rose in 2021 and 2022, the Federal Reserve famously waited too long to raise interest rates, causing consumer prices to continue to rise sharply, Fed officials now admit.
Now that inflation is easing, the Fed may be poised to make another mistake by cutting interest rates too slowly and triggering a recession, some economists argue.
“The longer they wait, the greater the risk that something goes off the rails,” said Mark Zandi, chief economist at Moody's Analytics.
With annual inflation nearing the Fed's 2% target and some risks to the economy increasing, Zandi said the Fed should begin cutting rates in March or May at the latest. Based on the two most popular measures, inflation is around 3% or slightly below, falling from a 40-year high of as much as 9.1% in June 2022.
But Fed Chairman Jerome Powell said last month that a rate cut in March was highly unlikely. And minutes from the Fed's late January meeting released this week have led some economists to push back their forecasts for the first rate cut to June or later.
Many of them say inflation is still the bigger threat and the Fed is on the right track.
“I think it’s right to be patient,” says Barclays economist Marc Giannoni.
What is the current Fed interest rate?
From March 2022 to July 2023, the Fed raised its benchmark short-term interest rate from near zero to a 22-year high of 5.25% to 5.5% to help contain pandemic-related inflation that was already slowing Supply chain problems abated. Since then, the central bank has kept the interest rate stable.
A reduction in the federal funds rate would reduce borrowing costs for mortgages, credit cards, cars and other consumer and business loans, thereby stimulating the economy. The prospect of lower interest rates has already pushed the stock market to record highs.
But after his two-day meeting last month, Powell told reporters that before cutting the rate, officials want to gain more confidence that inflation is “on a sustainable path to fall to 2%.” According to the minutes, most policymakers were concerned about the risk of moving too quickly to cut interest rates and restart inflation. Only “some” officials highlighted the risk of keeping interest rates high for too long and significantly weakening the economy or slipping into recession.
Is inflation really high right now?
Several reports since the Fed meeting appear to have confirmed the Fed's cautious approach. A “core” measure of inflation that excludes volatile food and energy goods rose a strong 0.4% in January, keeping the annual increase at 3.9%, according to the consumer price index.
Is the US economy currently strong?
Last month, meanwhile, U.S. employers added a booming 353,000 jobs and average annual wage growth – which impacts inflation – rose to 4.5% from 4.3%.
The economy also grew at a robust annual rate of 3.3% in the final three months of 2023 and at a solid 2.5% for the year as a whole.
The takeaway: Not only is the economy on solid footing, but it could also push inflation back up as consumers continue to spend their rapidly rising paychecks.
Some forecasters disagree.
Will the rent go down?
Admittedly, inflation rose sharply in January, but that was only a month ago, and that was largely due to continued increases in rent and other housing costs, Zandi says. Rent increases are expected to ease in the coming months as falling interest rates on new leases impact existing leases.
Additionally, another measure of inflation that the Fed watches more closely – the so-called personal consumption expenditures price index – was at 2.6% in December, and the Fed's preferred core reading was 2.9%, not far from the 2% target.
And if you annualize the increases in core consumer spending index prices over the last six months, inflation is already at 1.9%, Zandi notes.
By that standard, “you’ve achieved your goal,” he says.
Are layoffs increasing?
Meanwhile, the economy is not as robust as it seems. Although employment gains were strong, employers' hiring rates in November reached their lowest level since 2014, excluding the pandemic recession. In other words, net job gains were strong because employers were unwilling to lay off workers due to severe pandemic-related labor shortages (aside from high-profile layoffs by companies like Amazon, Google, and Microsoft).
And although the country's gross domestic product grew significantly last year, an alternative measure of economic output that some analysts consider more accurate – gross domestic income – rose only modestly.
Zandi, for his part, argues that the risk of plunging the economy into recession is now greater than the probability of driving up inflation.
“You have to be careful not to let the economy slow down for too long,” he says.
Ryan Sweet, chief U.S. economist at Oxford Economics, agrees.
“If the central bank waits for clear signs that the labor market or overall economy is deteriorating, it will fall behind the curve,” he wrote in a note to clients.
Zandi is particularly worried about an unforeseen banking crisis like the one that brought down Silicon Valley Bank and other regional banks a year ago. High interest rates mean lower profit margins, which discourages banks from lending.
And while companies have been hesitant to lay off workers, “that can change quickly,” he says, as high tax rates drive up the cost of doing business while dampening sales. Falling profit margins could prompt more companies to cut employees to maintain profits, he says.
Economists forecast economic growth will slow to a still-decent 2.1% this year, but see a 36 percent chance of a recession, according to the average estimate of forecasters surveyed by Wolters Kluwer Blue Chip Economic Indicators. That's down from May's 61% rate, but still a historic high.
According to a model that takes into account a variety of economic indicators – including GDP, jobs and inflation – the Fed's key interest rate should already be at 4% instead of 5.25% to 5.5%, Zandi says. That would still be well above the Fed's long-term interest rate estimate of 2.5%.
Will inflation rise again?
Giannoni, the Barclays economist, agrees that the risks of further price rises are becoming increasingly balanced against a recession. But he believes inflation is still the biggest concern.
“We were continually surprised by the strength and resilience of the economy,” he says. “There is ongoing risk and that means the path to 2% inflation is not guaranteed.”
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While inflation in the private consumption expenditure price index has fallen, it could rise again, according to Giannoni. Prices for services such as health insurance, car insurance and dining out have continued to rise sharply, partly due to labor shortages that have led to large average wage increases for workers, he says.
But what about the risk that high interest rates could plunge the economy into a downturn?
“I don’t think the likelihood is high,” Giannoni says.