By Nick Timiraos
For investors, the big question hanging over this week's meeting of the Federal Reserve is whether it will wait a little longer to cut interest rates because of recent, firm inflation readings.
The Fed, though, has a different preoccupation: If it waits too long, will it inadvertently cause a recession?
Officials won't put recession risk front and center this week. Yet that risk is likely to drive its thinking over the remainder of the year, leaving it on track to cut rates at some point.
The central bank will keep its benchmark interest-rate target at a range of 5.25% to 5.5%, a 23-year high, when its two-day meeting ends Wednesday. The focus will be on its latest interest rate and economic projections.
In their latest projections in December, most officials thought a key gauge of inflation would fall from just above 3% at the end of 2023 to just below 2.5% at the end of this year. Most anticipated three quarter-point rate cuts this year.
Since then, inflation in both January and February has been higher than expected. Investors are intensely focused on whether officials still project three cuts or just two. They will also hunt for clues from Fed Chair Jerome Powell's news conference over whether the first cut is still possible in June, as futures markets currently anticipate, or later.
Earlier this month, Powell suggested the central bank was on track to cut rates by midyear as long as monthly inflation data assured them a downward trend was still intact. "When we do get that confidence, and we're not far from it, it'll be appropriate to dial back the level of restriction so that we don't drive the economy into recession," he told lawmakers on Capitol Hill.
Since then, monthly inflation came in higher than expected in February. The question is whether that was a fluke and the downward trend from the last six months of 2023 will resume, or alternately, whether that slowdown was itself the aberration.
Is pre-emption warranted?
The fixation on interest-rate projections this week obscures a bigger shift inside the Fed in the past year, with bigger implications for the economy.
The reason rates are above 5% today is that the world looked different in the summer, when the Fed pushed them to this level. At the time, officials feared inflation might become entrenched at 3% or higher, unacceptably above officials' 2% goal. The only way to bring it down would be through much weaker growth and higher unemployment, which is what higher rates were presumed to deliver.
Instead, inflation has fallen rapidly despite solid output and hiring. Healing supply chains brought down goods prices and an influx of foreign-born workers held down wage growth and boosted demand.
Fed officials are less worried inflation will get stuck above 3%. Even after February's uptick, inflation by the Fed's preferred measure was likely below that.
The concern, rather, is that inflation takes longer to reach 2% because services inflation remains "sticky" and slow to fall or because demand for, and prices of, goods rebound. Rather than raise rates, the central bank can respond to this by waiting longer to cut rates.
Inflation in both January and February has been higher than expected. PHOTO: SHELBY TAUBER/BLOOMBERG NEWS
At this week's meeting, the debate is likely to center on what it would take to commence rate cuts by midyear.
Inside the central bank, one camp sees no need to cut since the economy is strong and wants more evidence of a slowdown. This group has been in the minority though it has the wind at its back with recent disappointing inflation readings.
"There is no need to pre-emptively adjust the stance of policy" given above-target inflation, strong demand, and low unemployment, said Kansas City Fed President Jeffrey Schmid in a speech this past month.
Another camp is more attentive to signs of weaker demand and hiring. The unemployment rate, at 3.9% in February, has edged up from a recent low of 3.4% in April 2023. Historically, when the unemployment rate goes up a bit, it ends up going up a lot.
Some of these officials are ready to cut rates as soon as the inflation data gives them the chance in order not to squander a momentous opportunity for a so-called soft landing.
Risk-management trade-offs
What officials ultimately do boils down to what problem they decide is easier to fix, a process called "risk management." If demand is stronger and inflation stickier than expected, the Fed can postpone cuts. If demand and hiring weaken more than anticipated, the Fed has ample room to cut rates -- but probably won't be able to move quickly enough to forestall a recession.
A growing number worry more about the latter scenario than the former. "We have to be forward-looking and make sure that we don't give people price stability but take away jobs," said San Francisco Fed President Mary Daly in a December interview.
Fed governor Lisa Cook said officials raised rates above 5% this past summer as a prudent response to the "quite salient" risk that inflation would get stuck above 3%. That risk has diminished though it hasn't disappeared, she said in a speech in February.
"As we gain greater confidence that disinflation is ongoing and sustainable, that changing outlook will warrant a change in the policy rate," said Cook.
Even if policymakers are inclined to cut rates, they need a credible justification if there is no obvious deterioration in the broader economy. A resumption of falling inflation would provide that justification, which makes price data in the next month especially crucial.
The adverse turn in the latest inflation data is a sobering reminder of how hard it is to stick the soft landing. "There are a lot of things that have to simultaneously go right," said Cayla Seder, an investment strategist at State Street. "If rates are elevated that increases the risk of a hard landing.