The US Federal Reserve is cutting interest rates at a rapid pace, even though the American economy is still in good health.
There was no reason to panic. And yet the committee around Fed Chairman Jerome Powell allowed itself to be influenced by the increasingly loud warning voices. They demanded that the central bank reduce the key interest rate by a high 0.5 percentage points – instead of a step of just 0.25 percentage points, as the Fed usually chooses in calm times. The monetary authorities fulfilled their wish. The accusation from their critics that they were leading the USA into a recession with their hesitation obviously hurt them.
The USA is doing well
But there is currently no evidence of an economic downturn. The US GDP is growing by more than 2 percent, and according to the latest estimates from the Atlanta Fed, even by 3 percent per year. Americans’ wages are currently rising by more than 4 percent over the whole year, and their consumer spending is also increasing. These are figures that would be celebrated in Europe as a medium-sized economic miracle.
The fact that more Americans are looking for jobs than a year ago is mainly due to a larger supply of workers, not least because of the high level of immigration to the USA. Layoffs are still rare.
Jerome Powell also raised these points when he explained to the assembled press on Wednesday how the Fed assesses the economic situation in the USA. What Powell did not say, but what many market participants thought: The Fed leadership has come to the secret conclusion that it should have lowered the key interest rate in July. And now it wants to make up for the supposed oversight with a double reduction.
There is no good reason for this. Middle- and high-income Americans, who account for a large share of consumption, have significant financial reserves, thanks in part to the booming stock market.
They are less likely to give up on restaurant visits and vacations and will stabilize the economy even if the labor market weakens somewhat. Many low-income Americans no longer have such reserves. But as long as the labor market remains stable and they keep their jobs, they too will only limit their consumption to a minimal extent.
In this sense, it was not crucial that the central bank get out of the starting blocks as quickly as possible. What is more important is to anchor the market’s long-term expectations of where the journey should go. A reduction of 0.25 percentage points would have been sufficient for this if the Fed had communicated this carefully.
The consequences of previous mistakes
There is now a risk that market participants will misinterpret the Fed’s move as an alarm signal. American stocks and bonds briefly rose in value after the interest rate decision, but gave up these gains very quickly. This could be a sign that the market has already priced in the major interest rate hike – or that it suddenly no longer trusts the optimistic economic forecasts.
It should not be forgotten that the Fed is still trying to regain the public’s damaged trust. Three years ago, when inflation in America shot through the roof due to the long-term effects of Corona and lax monetary and fiscal policy, the Fed initially sat back and did nothing. It kept interest rates at record low levels because it expected the surge in prices to be only temporary.
The Fed was wrong – and ran the risk of losing control of long-term inflation expectations in the market in 2022. For a central bank, that’s pretty much the worst thing that can happen: If companies and unions no longer trust the Fed, its monetary policy is less effective. The risk of wages and prices getting out of control increases. The central bank must then take drastic and all the more painful measures to get inflation expectations under control again.
Avoidable risk
Jerome Powell recognized this danger in the summer of 2022 when he issued the slogan at the annual central bankers’ meeting in Jackson Hole that, if necessary, a recession would be accepted in order to bring inflation under control.
Two years of hard work have now borne fruit: inflation is slowly approaching the 2 percent mark, where the Fed would like it to be. Inflation expectations remain well anchored.
But the Fed has not quite reached its goal yet. Housing costs in the country in particular are continuing to rise sharply, something Powell also admitted on Wednesday. And of course it is always possible that raw materials, especially oil, could suddenly become more expensive again due to geopolitical uncertainty.
If inflation unexpectedly picks up again, the Fed will now have to choose an unpleasant stop-and-go strategy. This risk was avoidable.