America’s economy is hot. So why is the Fed even considering a rate cut?

Washington, DCCNN — 

The Federal Reserve is widely expected to hold interest rates steady Wednesday for the fourth consecutive meeting, leaving them at a 23-year high as policymakers likely discuss the timing of rate cuts.

Investors will be paying close attention to the central bank’s policy statement and Fed Chair Jerome Powell’s post-meeting news conference for any signs that the first rate cut could come in March — or not. The broader US economy remains on strong footing, the job market is still robust and inflation hasn’t yet reached the Fed’s 2% goal, so there doesn’t seem to be any urgency to cut rates at the moment. Fed officials have communicated as much in recent public remarks.

But nearly two years of punishing rate hikes have frozen the housing market and are starting to drag on the rest of the economy. So if the Fed acts too late in pulling back on its aggressive action, it risks what it has (shockingly) avoided so far: plunging the US economy into a recession.

That’s because, if inflation drifts lower but interest rates remain elevated, it causes “real” interest rates to rise, unnecessarily squeezing the economy and risking job losses.

Another important, if less dire, reason to start thinking about rate cuts: Financial markets are still pricing in a decent chance of that first cut coming in the spring. The Fed doesn’t officially take the stock and bond markets into consideration when making its decisions — but it has no interest in tanking your portfolio either.

And while the Fed isn’t expected to signal that it will cut rates anytime soon, the central bank will likely stop short of completely ruling out that possibility, since the Fed’s March 19-20 meeting is several weeks — and many economic reports — away.

“It really is about how hard they push back against the potential for cuts as soon as March, or if they don’t push back,” Sarah House, senior economist at Wells Fargo, told CNN in an interview.

“We’ll be looking at their emphasis on how restrictive policy is, any concerns around the labor market and how the [Fed] is viewing the risks to inflation’s outlook,” she said.

House said Fed officials could update their characterization of inflation in the policy statement by omitting the part that says it “remains elevated,” and replacing it with something more neutral. That would be a sign that the Fed is inching closer to cutting rates.

No urgency for rate cuts

After the Fed signaled last month that it is no longer leaning toward hiking rates, Wall Street pounced on that shift and ran with it. At one point, the odds of a March cut were north of 75% in mid January, according to futures, prompting Fed officials to come out and temper that rabid optimism through public remarks.

“When the time is right to begin lowering rates, I believe it can and should be lowered methodically and carefully,” Fed Governor Christopher Waller said earlier this month during a virtual discussion. “With economic activity and labor markets in good shape and inflation coming down gradually to 2%, I see no reason to move as quickly or cut as rapidly as in the past.”

US Federal Reserve Chairman Jerome Powell holds a press conference at the end of Monetary Policy Committee meeting in Washington, DC, on December 13, 2023.

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The odds of a March cut are now down to around 37%.

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“While I think it’s appropriate for us to look forward and ask when would policy adjustments be necessary so we don’t put a stranglehold on the economy, it’s really premature to think that that’s around the corner,” San Francisco Fed President Mary Daly, who votes on interest rate decisions this year, told Fox Business recently.

Not only does the economy remain in good shape, but officials have plainly said that they’re not yet convinced that inflation is on a certain path toward 2%.

So what would be the rationale for cutting rates so soon?

A rapidly weakening economy threatening mass job losses is an obvious reason to cut rates, which most economists aren’t currently forecasting. In fact, many now are expecting inflation to drift closer to 2% without a spike in unemployment, a rare outcome known as a soft landing.

But another concern that has gained some traction is the rise of inflation-adjusted interest rates, which is an argument for rate cuts.

If inflation continues to descend, but rates remain unchanged at an elevated level, that would inherently mean that “real” rates are rising, constraining the economy and squeezing employers.

Chicago Fed President Austan Goolsbee told CNBC recently that “if we continue to make surprising progress faster than was forecast on inflation, then we have to take that into account in determining the level of restrictiveness.”

A robust economy without rising inflation

Recent economic data has been encouraging. The US economy expanded at a seasonally and inflation-adjusted 3.3% annualized rate in the final months of 2023, a healthy pace of growth, as the Personal Consumption Expenditures price index excluding food and energy prices held steady at 2% for the second quarter in a row.

Thomas Barkin, president of the Federal Reserve Bank of Richmond, during a Virginia Bankers Association and the Virginia Chamber of Commerce event in Richmond, Virginia, US, on Thursday, Jan. 11, 2024. Barkin last week said the central bank can lower interest rates as the economy normalizes and confidence grows about the downward path of inflation.

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Consumer spending also remained strong in December, showing that Americans aren’t quite yet pulling back, according to the latest monthly PCE report released Friday. Meanwhile, US consumers have continued to rack up debt in recent months, but that might not be a huge issue just yet.

“There are concerns about higher delinquency rates, credit card debt, and student loan debt having an impact on the consumer, but as long as people are employed and job creation remains strong, I think those concerns are less prominent,” Subadra Rajappa, head of US rates strategy at Société Générale, told CNN.

Indeed, employers continue to hire at a solid clip and Americans are still enjoying robust wage gains that are beating inflation, helping fuel spending and keeping the economy’s head above water. Consumer spending accounts for about two-thirds of the US economy.

The Labor Department is releasing a slew of economic data this week gauging the state of America’s job market. Job openings picked up slightly in December as layoffs remained well-below pre-pandemic levels, the department reported Tuesday.

On Friday, the year’s first jobs report is due, which will outline how many new positions employers added in January, as well as the unemployment rate that month.

The Fed is set to announce its latest policy decision at 2 pm ET on Wednesday, followed by a press conference from Chair Powell at 2:30 pm ET.

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