Walking the Federal Reserve’s Policy Tightrope
Unless the Fed keeps interest rates elevated until inflation is closer to its goal, risking a moderate recession now, it risks more severe economic consequences in the long term
Economic forecasting is always a hazardous undertaking, and never more so than now. Monetary policy has rapidly swung from highly accommodative to restrictive and now is on hold. The current higher interest rates and fewer reserves being made available to the financial industry—a strategy known as quantitative tightening (QT)—have been necessary to bring down inflation. But the markets already are discussing the timing of interest rate cuts and an end to QT. At last week’s Federal Open Market Committee meeting, the Federal Reserve (Fed) signaled this will happen sooner rather than later, although the economy just completed a quarter of exceptional GDP growth and inflation remains uncomfortably high.
And if that’s not enough, the national debt is exploding and record budget deficits are projected through the next decade, further complicating the challenges that confront the Fed. The Fed is walking a narrow tightrope as it balances the policy tradeoffs in its pursuit of low inflation and sustainable economic growth.
The Fed knows it must slow the economy to bring inflation to its 2% goal. It expects its current policy will be successful and avoid a recession. However, the risk of recession remains elevated, and as difficult as that might be, it is better for the Fed not to change direction too quickly. A moderate recession now is preferable to a more severe one later, with all its more costly effects. Just as important, the Fed should encourage Congress to address the nation’s long-term danger of spending itself into crisis.
The Fed insists that it will reestablish price stability, defined as a 2% annual inflation rate. To achieve this goal, it is using two policy tools. First, it is employing its go-to policy of higher interest rates, increasing the fed funds rate from 0.25% a year and a half ago to 5.5% currently.
Second, the Fed is employing a QT strategy, reducing its balance sheet and reserves available to the financial industry. Over the past year its balance sheet has declined from $9 trillion to just under $8 trillion, constraining the growth of bank deposits and market liquidity and complementing its higher-interest-rate policy.
As expected, these actions are slowing economic activity. Residential real estate sales have slowed, some real estate prices are declining and rent increases are slowing. Construction of commercial real estate and multifamily dwellings is slowing. Also, private investment has slowed, but government subsidies for chip technology, green energy and infrastructure have kept overall investment level over the past months.
Another factor slowing the economy has been an injured banking industry, as higher rates and QT have reduced bank liquidity and weakened balance sheets. Banks have tightened credit, and capital markets have become more cautious. Throughout 2023 the industry has experienced increases in nonperforming loans, including both commercial and industrial, and more recently consumer credit has shown weakness. This past March three large regional banks failed, and the industry encountered its first liquidity crisis of this cycle.
As conditions deteriorated, the Fed reduced the size and frequency of its policy actions. Rate increases were as large as 75 basis points early in the tightening cycle, but then steadily reduced to 25 basis points, and since May rates have been raised only once. The Fed’s QT program also was temporarily interrupted during the banking crisis.
Despite the uncertainty and concern around the Fed’s tighter policy, the economy has performed surprisingly well. Third-quarter GDP expanded at an annual rate of 5.2%, well above what most economists predicted earlier this year and above the economy’s long-run potential growth rate. Labor demand, while moderating, also remains strong, and several negotiated settlements have led to significant wage increases. Average hourly earnings increased at an annual pace above 4% for each of the past three months. This spurred continued strength in consumer spending, a driving force behind the economy’s stronger-than-expected performance.
Additionally, inflation has continued to decline modestly from month to month. Year-over-year CPI inflation declined from 9% in June 2022 to 3.1% this November, and Core CPI inflation, which doesn’t include food and energy, is running at a 4% year-over-year rate. These rates are still well above the Fed’s 2% target, but the Fed takes comfort in their steady decline.
A growing consensus among forecasters is that the economy will suffer only a modest slowdown in the near term, raising the odds that it will achieve the fabled soft landing—returning to a 2% inflation rate without a significant recession. The Fed too is projecting no recession. Instead, it is anticipating, at worst, an economic slowdown in GDP growth this quarter, then strengthening in 2024 and 2025. This favorable outlook has caused the Fed to stop its rate increases on the assumption that doing so won’t reignite inflation.
However, another motivating factor for the Fed’s stand-down on rate increases is last March’s banking turmoil and the industry’s continued vulnerability to current higher rates and declining asset conditions. The banking industry is reporting nearly $700 billion in unrealized losses from its securities portfolio. Given that securities represent only 25% of the industry’s assets, what unrealized losses still remain to undermine industry performance?
The combination of better-than-expected economic performance, a decline in inflation and uncertainty about financial resiliency has prompted politicians, Wall Street and many within the Fed to call for an end to rate increases (now) and for lower rates (soon). The administration also may want the Fed to end QT because the Treasury auctions massive amounts of debt to meet its spending needs, which over time could tighten market liquidity further and place upward pressure on interest rates.
Thus, despite stating that returning to 2% inflation is the goal, the Fed has expanded its ambitions to do so without a recession. Rather than continuing with its tighter policy, it will rely on the lagged effects of prior rate increases to methodically, and reliably, slow the economy and return inflation to its 2% target over time.
It’s understandable why some policymakers are pushing the Fed to lower rates. The longer rates remain elevated, the more likely a recession becomes. Compare this business cycle with that surrounding the financial crisis of 2008. Following the recession of 2001, the Fed systematically lowered rates to 1% in the spring of 2003 and left them low for too long, until inflation approached 5%. The Fed then changed direction and, over the next two years, raised rates from 1% to 5.25% in June of 2006, where rates remained until the summer of 2007. At that point the economy turned sour, eventually ending in crisis and recession.
The timing of events is significant: Bear-Sterns failed in March 2008, Fannie and Freddie in August 2008 and Lehmann in September 2008. The great financial crisis arrived more than two years after the Fed stopped raising rates.
The Fed is aware of this timeline and has concluded that although inflation remains above target, the lagged effects of its policies—higher rates and QT—will deliberately and inevitably slow the economy. To raise rates further or keep them higher for longer could repeat the experience of the 2008 crisis. Thus, the thinking goes, although inflation remains above 2%, the Fed should cease its restrictive monetary policy and, thereby, reduce the likelihood of a financial and economic crisis.
Those advocating for this adjusted policy also note the slowing economic effects of uncertain geopolitical winds and other external factors. Trade frictions are not receding and will hurt growth. The rest of the world’s economies are struggling and are less a source of growth for the United States than they were formerly. Global conflicts are increasing in size and scope, which affects U.S. growth and inflation.
Thus, the Fed’s choice to shift its policy is understandable, and the recent Fed projections showing three interest rate cuts in 2024 confirm its shift toward a goal of avoiding a recession. However, this shift also involves high risks, both immediate and long-term.
An Uncertain Future
This change in policy reintroduces uncertainty about the Fed’s commitment to achieving the 2% inflation goal. Ceasing rate increases while inflation remains relatively high (over 3%, with core inflation at 4%) risks raising inflation expectations. This by itself increases the difficulty of reaching the 2% inflation goal, as business and labor will begin to anticipate rising inflation in their wage and price strategies.
Also, if the Fed cuts rates to stimulate the economy while inflation remains above target, its action could readily reignite inflation. This happened in the 1970s with a repeated policy pattern of slow growth, monetary stimulus, inflation, restriction, recession, then more stimulus until inflation reached an astonishing 14%. At that point the Fed was compelled to raise interest rates to 20%, which finally broke the inflation cycle, but at a terrible price in lost growth, higher unemployment and lower income across the economy.
The Fed’s repeating such a stop-go pattern is no small risk. Its track record over the past two and a half decades is to bail out markets quickly with large liquidity injections that are withdrawn only slowly. This began in the ’90s with the Mexican crisis, followed by a liquidity crisis involving Asia and Russia and the collapse of the dotcom bubble. Such bailouts took on a new dimension during the Great Recession with the introduction of quantitative easing. The Fed now has an established record of injecting trillion of dollars of reserves—quantitative easing—into the banking system, not only at the time of crisis but for long periods afterwards. Many in the market expect the Fed to continue this pattern should a recession threaten. If the Fed does so, the risk of repeating the pattern of the ’70s is high.
The risk of a policy error is great whichever policy path the Fed may choose, but ultimately, history suggests that failing to meet its inflation goal carries the greater long-term risk to the economy.
The Other Elephant
Finally, what path the Fed chooses this economic cycle has implications for how it will handle the other elephant in the room—the growing federal debt burden and the Fed’s role as buyer of last resort.
If the Fed continues to print money as it has over the past decade, it will undermine the U.S. economy’s growth potential. As the federal government and the Fed itself have engaged in their highly aggressive policies, they have changed the balance of supply-and-demand forces within the economy. Earlier this year the Congressional Budget Office (CBO) released its fiscal projections for the next decade, which are striking in their implications. For example, the federal debt held by the public will increase by $22 trillion by 2033, to a level of nearly $50 trillion, or 118% of GDP. The federal deficit exceeded $1.7 trillion this past fiscal year and is projected to reach nearly $3 trillion before 2033, or 7.3% of GDP. Interest on the debt alone will exceed 3.5% of GDP by then.
The Fed has been a contributor to this explosion of debt. From the 2008 financial crisis through the pandemic, the Fed has been a significant purchaser of the federal debt and in doing so has artificially suppressed interest rates. Its balance sheet has expanded exponentially as it has created—printed—the dollars to do so. Given the CBO numbers, the Fed will soon be under pressure again to purchase the ever-growing national debt going forward, which will remove all discipline around the federal government’s ability to borrow and spend.
Having a nation’s debt grow faster than its income is not sustainable: It places upward pressure on interest rates, slows private investment and constrains real economic growth. Among the CBO’s projections, real GDP is expected to fall from an average longer-term historic rate of 2.3% per year to 1.8% for the decade ahead. Such a slowdown would reduce the nation’s real income by well over a trillion dollars from what it would have been at its historic rate.
These data and projections forecast a U.S. economy that is less dynamic in the future. As the growth in federal debt accelerates and the private sector’s access to credit is crowded out, there will be political pressure for the Fed to return to buying government debt and to suppress interest rates to fund both private and public borrowing. Unfortunately, this will multiply the risk of reigniting inflation that would further undermine economic growth.
Thus, the challenge for policymakers goes beyond the immediate goals of reducing inflation while avoiding a recession. While finding a way through these difficult times, the Fed must also anticipate the effects of government spending as it balances short-run and long-run policies of its own. To avoid a crisis, Congress must put its tax-and-spending house in order. It has done so in the past and can do so again; but it will require a bipartisan effort. If it fails to do so, the Fed must play the bad guy and refuse to monetize the debt, or it will fail in its long-run mission to achieve stable prices, maximum employment and stable interest rates.