The Fed Faces a New Dilemma

For the first time in years, the Federal Reserve faces twin risks and must decide which it wants to avoid more.

Inflation was a very low risk for many years before it surged in 2022. It has been inching lower but remains above the Fed’s target.

Inflation has been sticky because of solid economic growth, supported by steady increases in household income and strong household and business balance sheets.

For inflation to fall to the Fed’s 2% target, consumer incomes and savings need to dip enough to reduce retail spending growth.

But if the Fed keeps monetary policy tight to ensure inflation reaches its target, economic growth could slow too much. The economy might tumble into a recession.

Yet, unlike in the years before 2021, if the Fed eases too much or too soon, inflation might surge.

Many Fed officials made clear they would like to reduce interest rates.

But easing too much or too soon could reverse the progress on inflation. The Fed doesn’t want inflation to become embedded in people’s minds and the economy the way it was in the 1960s and 1970s.

Complicating the Fed’s job is that total assets and equity holdings of households are at their highest levels ever, thanks to rising prices for stocks and homes.

Each time investors become more optimistic about interest rate cuts, prices of stocks and homes rise. When net wealth increases, consumers are more confident and more likely to spend. That supports inflation.

The Fed faces asymmetric risks. It likely views a slumping economy as a greater danger and harder to reverse than rising inflation. If monetary policy stays too tight for too long, an economic downturn could become self-reenforcing and more difficult to reverse.

The Fed has been following the gradual weakening in the labor markets and the economy and doesn’t want those declines to accelerate.

That’s why the Fed is likely to ease once or twice by the end of 2024.

When assessing inflation, the media and most investors focus on the Consumer Price Index or the Personal Consumption Expenditure (PCE) Price Index.

But many Fed officials are said to follow what some call the super core PCE Price Index, which excludes prices of food, energy and housing, shown in the chart nearby.

In the short-term, food and energy prices tend to be volatile, and people buy them regardless of price changes. None of the main price indexes does a good job of measuring housing inflation. Excluding these three items is thought to do a better job of showing how prices in general are responding to monetary policy.

This index currently supports reducing interest rates at least once this year.

There are several other factors to monitor to determine if monetary policy is too tight or too loose.

Surges in gold, stocks and bitcoin indicate the level of liquidity in the economy. Commodity prices also tend to react quickly to changes in liquidity and growth. Recently, most of these factors indicate monetary policy shifted from very easy to less easy.

When long-term treasury bond interest rates rise, that indicates investors are worried either inflation is too high or market liquidity isn’t adequate to fund government spending. Since late October 2023, treasury bond interest rates indicate investors don’t have those concerns.

The Fed isn’t likely to reduce interest rates as much as the markets expect, so any cut isn’t likely to have a big effect on stock and bond prices. Market prices already anticipate several cuts.