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The US Federal Reserve building in Washington DC, US. Picture: JONATHAN ERNST/REUTERS
The US Federal Reserve building in Washington DC, US. Picture: JONATHAN ERNST/REUTERS

Washington — As victory celebrations go, the US Federal Reserve’s (Fed’s) announcement of a quarter-point interest rate cut in July of 1995 was hardly ostentatious.

“As a result of the monetary tightening initiated in early 1994, inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions,” the Fed, then led by Alan Greenspan, said as it began to loosen its grip on the economy after nipping incipient inflation and with such good timing that the unemployment rate continued what would become an eight-year decline. Jobs and economic growth that had been ebbing into a possible recessionary spiral both picked up.

It is a moment Fed chair Jerome Powell and his colleagues want to emulate, offering a case study of a “soft landing” from price pressures. For Powell to complete the journey from allowing inflation to erupt on his watch to navigating it back to the central bank’s 2% target without a recession, he will need to see the cycle through to that first rate cut.

Conjecture over the timing is now in full swing.

Investors bet it will start no later than May, while new projections from Fed officials on Wednesday after a two-day policy meeting are expected to show rates lower by the end of 2024 but without any detail on the timing of the start of cuts.

Policymakers are likely to remain skittish about declaring victory over inflation even though economic data increasingly resemble the conditions Greenspan faced in 1995, with inflation seeming to be set to slow, overbuilt inventories posing a drag on future investment, a likely tightening of government spending and consumer spending expected to wane.

Back then that begged the question of why the Fed’s rate should remain as high as it was, at 6%. It’s a query current Fed officials are likely to remain reluctant to answer for now, particularly after a strong November jobs report.

The December meeting “is more likely to be a last hurrah for policy caution”, Evercore ISI Vice Chair Krishna Guha wrote ahead of the Fed meeting. “We expect little specificity” about what will guide policymakers towards the timing and extent of rate cuts.

If 1995 is a guide, the case may hinge on how the job market, credit, consumer spending and inflation itself all behave over the next few months.

If 1995 is a guide, the case may hinge on how the job market, credit, consumer spending and inflation itself all behave over the next few months.

The Greenspan Fed, as that year evolved, became confident it had laid the groundwork for continued “disinflation” since economic growth was below potential and seemed poised to slow. The Powell Fed may be approaching the same spot.

Blowout third-quarter economic growth was driven by consumption and investment figures not expected to be repeated, with overstocked inventories likely to drag on output in coming months. Consumer spending is also seen ebbing, in part as higher interest rates slow consumer credit. Companies may also face tighter credit.

All of that should feed into diminished job and wage growth, and steadily slowing inflation.

Consumer prices in October, indeed, did not increase at all.

What will foretell the pivot is Wall Street’s new obsession.

Citi analysts argued recently that the job market “will become increasingly important for the outlook for rate cuts”, with continued strength in hiring a reason to leave the current policy rate unchanged in the 5.25% to 5.5% range.

The unemployment rate fell in November to 3.7% from 3.9%, and three-month average job gains remain above 200,000, higher than the 183,000 in the 10 years before the pandemic.

Bank of America US economist Michael Gapen said he thought the cue will come from the inflation numbers. Rate cuts come into view, he said, once the Fed’s targeted inflation measure, the Personal Consumption Expenditures (PCE) Price index, falls “clearly below three” on an annual basis, with the trend over three- and six-month time frames perhaps at 2.5% or lower.

“That would give you further confidence that inflation is slowing,” he said in November.

In Powell’s latest comments he noted PCE had hit 2.5% in recent months, while Fed governor Christopher Waller noted separately that a continued steady decline in inflation for “three months, four months, five months” would justify rate reductions under many standard rate-setting rules.

If that progress stalls, however, rate cuts would be pushed further out, and any sign of inflation resurgence is likely to be met with renewed discussion of further rate increases. Any cuts to come are also likely to lack any firm promises about future reductions.

The Fed probably will not, as Waller noted, be trying to mount an economic rescue, instead aiming to keep policy in line with falling inflation.

It would be managing the risk, in other words, of restraining the economy more than needed to finish its inflation fight, instead of trying to open the monetary taps as happens in response to the sort of shocks that can bring on recession fast.

The meltdown of tech stocks in 2000, for example, prompted the Fed to chop nearly 5 percentage points from its roughly 6.5% federal funds rate from January to December 2001. From September 2007 to December 2008 the Fed cut rates in similarly aggressive fashion in response to a housing market crash and financial crisis.

Greenspan’s rate cut in July 1995, by contrast, was not followed by another reduction until that December, and again in January. Rates stayed steady from there until March 1997, when they were increased.

It was part of the “Great Moderation”, an era when inflation became anchored after the volatile spikes of the 1970s and 1980s, and both growth and employment remained strong through much of the decade.

Powell has often cited similar periods of long expansion as the best operating case, where the gains of low unemployment spread to the less well-off, and households can make steady progress.

In his last public comments before the December meeting, Powell said the coming period is one for the Fed to move “carefully” as the one-sided risk of inflation came into more balance with the risk of the Fed going too far.

“The risks of under- and overtightening are becoming more balanced,” Powell said. “We don’t need to be in a rush now ... We’re getting what we wanted to get.”

Reuters

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