Why the US Federal Reserve's interest rate high-wire act matters to us all

The risks of holding the cost of money for too long or not long enough can have global consequences

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Two years after aggressively raising interest rates, the Federal Reserve is in a delicate balancing act as it aims to steer inflation back to its long-term 2 per cent goal. Getting it wrong will have spillover effects in the US and around the globe.

With rates likely at their peak target range and Personal Consumption Expenditure (PCE) Price Index showing inflation battened down to 2.4 per cent, the Fed is setting the stage for the next phase in its fight: cutting interest rates.

Fed officials have cautioned against declaring victory too soon even as a soft landing appears in sight.

And although the central bank still projects it will cut rates three times this year, it suggested recent bumpy inflation data warrants a careful approach moving forward.

“I don't think we really know whether this is a bump on the road or something more. We'll have to find out,” the Fed's chairman Jerome Powell told reporters last week.

“In the meantime, the economy strong, the labour market is strong, inflation has come way down, and that gives us the ability to approach this question carefully.”

That uncertainty is central to the Fed's coming decisions on interest rates.

“Part of the problem here is that they won't know that they've overdone it until it's too late because they'll only know it when the economy slows down and unemployment starts to rise. So the maths is a bit of a lag,” said Joseph Gagnon, senior fellow at the Peterson Institute for International Economics and a former senior economist at the Federal Reserve Board.

“By the time they realise that they have overdone it, they're going to be in a rush to cut rates and they may be too late.”

And their moves will be closely watched by other central banks in Europe, the UK and the Gulf, which are also preparing for rate cuts. The Bank of England and European Central Bank could begin dialling back as soon as June, which is when markets expect the Fed will issue its first rate cut.

“People seem to take a cue from the US, and when US interest rates rise other countries' rates rise, and we can debate about why that is, but it seems to be true,” Mr Gagnon said.

“That will be bad news for other countries in the sense that they'll see higher rates. It'll push the dollar up or push their currencies down, which maybe they don't want because that's bad for their inflation.

“It sort of desyncs the whole world.”

US Federal Reserve keeps interest rates on hold

US Federal Reserve keeps interest rates on hold

Going too early, however, runs the risk of seeing inflation reaccelerate. This would likely force the Fed to raise interest rates once more.

Again, this would affect the entire world, with other central banks forced to react to the Fed's decisions.

“When the Fed tightens, lending tends to flow to the US. And when money flows to the US, other central banks are forced to either raise interest rates or let their currencies depreciate,” said John Leahy, a professor at the Ford School and the Department of Economics at University of Michigan and former Fed visiting scholar.

Peter Andersen, founder of Andersen Capital Management, does not believe the Fed is in a position where it needs to cut interest rates this year.

“I consider the current rates as the most normal rate I have seen in many years, and also symbolic of a normally functioning economy, not an economy that's on crutches with low rates, not an economy that's crushed with super high rates, but if anything, slightly low to average,” said Mr Andersen.

While he commended the Fed for its progress against inflation with so much “soft data”, Mr Andersen argued dialling back this year would undo all the work the Fed has done after bringing the economy to a margin of safety.

“The margin of safety will shrink tremendously,” he said.

Still, the Fed remains in a delicate position, because as inflation has been steadily climbing down, the US unemployment rate has slowly been creeping up to its current level of 3.9 per cent.

Higher interest rates are meant to cool the economy in times of high inflation, but it also runs the risk of slowing the economy too much, which can eventually result in a recession or greater levels of unemployment.

“If the Fed doesn't loosen, and the economy goes into recession, that's a completely different situation,” Mr Leahy said.

“If the US economy goes into recession, the spillovers are basically that when the US economy goes into recession, generally Europe goes into recession. The world doesn't do well.”

He also believes the current Fed is distinct from previous administrations for taking more consideration of unemployment into its policy decisions.

“I think what this Fed is trying to do is trying to balance much more inflation and unemployment. And if there's any argument for cutting rates, it is that the you want to get ahead of a potential rise and unemployment coming later,” Mr Leahy said.

Adding to this uncertainty and difficulty is the novelty of this inflationary period. Unlike in previous cycles, much of the inflationary pressures were caused by supply-chain issues related to the Covid-19 pandemic.

Also surprising is the resilience of the economy in the face of the Fed's interest rates. Instead of falling into a recession, the US economy grew at a 3.2 per cent annualised pace last year.

“The difficulty the Fed is facing is that it's been hit with this series of fairly unique events. And it's managed remarkably well,” Mr Leahy said.

“The fact that we're even having this conversation is probably a good thing for them.”

Updated: March 29, 2024, 6:09 PM