The Bottom Line: Walking on a Razor Edge

For the Federal Reserve (Fed), the economy is in a sweet spot. Inflationary pressures have moderated significantly from last year, and demand for labor has slowed (chart 1). This helps reduce the cost of labor, a primary goal of the Fed in its attempt to bring inflation back down to 2.0%. Also, the Fed updated its outlook for Gross Domestic Product (GDP) growth next year, and they project the growth will be 1.5%, better than the June projection of 1.1%. 

At the same time, it is also a tricky time for the Fed. In this cycle, the Fed has raised the federal funds rate by 5.25 percentage points. It is one of their most aggressive interest rate hiking programs in recent history and pushed the rate well into the territory of restricting economic growth. Additionally, banks have become more stringent in lending policies, and small businesses are frustrated with the difficulty of accessing credit (chart 2). 

Famed economist Milton Friedman frequently talked about the long and varied lags of monetary policy. That is what is at play for the current Fed, as it has a tricky balancing act ahead of itself. In past cycles, after 18 months of tightening monetary policy, the Fed got the economic slowdown they wanted in most cases, and they started lowering interest rates (chart 3). That hasn’t happened this time around; consumer spending remains robust, which is keeping overall growth above trend. Also, inflation remains too high.

 

Fed policymakers must keep interest rates high long enough until they are convinced inflationary pressure will decrease and can be sustained at 2.0%. At that point, they may begin to lower interest rates to keep economic demand strong enough to support continued economic growth at a sustainable pace. The timing of that move will probably be in the second half of 2024, as the Fed waits out the lagged impact of the interest rate moves they have already put in place. 

Aside from the current tightening cycle, since 1955, the Fed has had 12 significant tightening cycles. Three of those have resulted in a soft landing when the Fed raised interest rates just enough to slow the economy and reduce inflation and then reduced them without causing a recession (chart 4).

 

The remaining nine times, a recession followed. The Fed didn’t cause all those recessions; for example, the pandemic caused the recent recession. But when interest rates move quickly, some businesses are more stressed than others, and sometimes there are dire economic consequences.  

This becomes the Fed’s walk on a razor’s edge. They have difficulty finding the precise time to move monetary policy and to determine by how much. If they hold interest rates high for too long, the economy risks entering a recession. If they lower them too soon, there is the risk that inflation may pop back up.