Federal Reserve to cut interest rates next year?

As expected, the Federal Reserve kept the federal funds rate the same this week, which influences other interest rates, including car and mortgage payments. The Fed also announced that next year, it might lower rates as many as three times during 2024.

Its stated reasoning is sound, though not ironclad. As inflation goes down, an unchanged federal funds rate actually goes up in real terms. Many economists think a good range for the federal funds rate is 1 to 1.5 percentage points above the inflation rate. For context, the current federal funds rate ranges between 5.25 and 5.50 percent, while inflation is somewhere between 3 and 4 percent, depending on the measure used.

This taking account of real and nominal rates is relatively new to Federal Reserve analysts. They made no such distinctions during the Great Depression, nor during the Great Inflation of the 1960s and 1970s. This is one reason the Fed made poor decisions during those periods.

The Fed did not make real-nominal distinctions as late as the 1980s, and even then inconsistently, per economic historian Allen Meltzer. The real federal funds rate ranged between negative 2 to 3 percent for most of the period from the 2007 financial crisis until last year, so the Fed’s commitment to real and nominal distinctions is at best inconsistent.

While the overall inflation news is good, there is still reason for caution. Presidents often pressure the Fed to lower rates during election years to goose the economy as people head for the polls. Assuming average lag times, the window for Fed decisions affecting the Election Day economic conditions runs from roughly now until mid-2024.

If the public starts to think that the Fed is cowing to the Biden administration the same way it did to the Johnson and Nixon administrations during the 1960s and 1970s Great Inflation, the effects could be bad. If markets come to expect today’s inflationary stimulus to continue, that will keep today’s inflation higher, no matter what the Fed does on monetary policy.

The Fed and the political branches caused the post-pandemic inflation. Congress and Presidents Trump and Biden went on a multi-trillion dollar spending binge, and the Fed financed it with the printing press. But the Fed has been doing more or less the right things for about the last year and a half. Next year will be an inflection point.

If Congress and the White House go on another spending spree, or if the Fed caves in to presidential pressure, inflation will go back up, and the Fed will lose credibility, making its already difficult job nearly impossible.