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Fed Pause Has Tightened Monetary Policy

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Fed’s Monetary Policy Tightens Amidst Uncertainty of Rate Cuts

Fed’s March Rate Cut

Markets were disappointed by Chair Powell saying March is not the Fed’s base case for its first rate cut at its recent Fed meeting. The Fed wants to see more progress on inflation, even though headline PCE inflation – the metric for the Fed’s 2% target – is already down to 2.6% YoY and core PCE is down to 2.9% YoY.

chart showing changes in inflation rates

Delay in Rate Cuts

Markets are now pricing the first rate cut in May. If they’re right, the Fed will have gone 10 months between its last hike in July and its first cut. Since the Fed’s last hike, though, inflation has been falling, pushing up real rates and making monetary policy more restrictive.

Real Interest Rates

The real fed funds rate is the nominal rate minus inflation. Another way to think of it is whether interest income is enough to offset rising prices. So while the Fed has paused the nominal rate at 5.5%, core PCE inflation has slowed from 4.2% YoY to 2.9%. That means this “pause” has seen real rates increase 130bps to 2.5%.

chart depicting changes in real interest rates with a projection of future rates

Significance of Current Real Rates

Research from Deutsche Bank shows that the Fed typically begins cutting rates when the real fed funds rate is between 2%-3%. At the start of the 2019-20 rate cut cycle, real rates were only about 1%. So current real rates are actually at – or above – a level consistent with past cuts.

chart showing comparison of real fed funds rates in past rate cuts

If you look at the chart above, you’ll notice that the Fed started cutting at progressively lower rates since the late ‘70s. In other words, a lower peak interest rate was needed to slow the economy. A big reason why is demographics. Since the ‘70s and ‘80s, the population has been aging, meaning we’ve seen slower labor force growth. When workers join the economy at a slower rate, economic growth naturally slows. In turn, the economy needs lower peak rates to cool it – which is exactly what we’ve seen. With demographics taken into consideration, a real interest rate around 1% seems to be enough to slow the economy now. So even if the Fed cuts as much as markets expect, real rates will be relatively restrictive. And that increases the risk of recession caused by leaving rates too high for too long.

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