No doubt, the Fed will keep rates unchanged at its upcoming meeting in mid-December, if only because the disinflationary trend is still firmly in place and most officials want more time to assess how past rate increases are playing out. It is also what investors expect, and the Fed rarely takes moves that would disrupt market conditions unless it wants to send a clear message to change investor expectations. The current message is that it will hold off on another rate increase for now, but it is not even thinking about cutting rates.
That said, the Fed’s patience in holding rates steady is not open-ended. If the economy and the job market continue to chug along at a faster than normal speed it is hard to see more of an inflation retreat. After all, the forces that pumped up the economy’s growth potential will not be around much longer. Returning workers and a surge in immigration sparked a rebound in the labor force – relieving worker shortages – but both have reached their limits. The labor force participation rate of prime-age workers is above its pre-pandemic peak, and the administration is cracking down on immigration. Indeed, the number of visas issued by the government fell by almost 50% over the past six months.
Meanwhile, with few exceptions supply chains have been fixed and goods are flowing freely to stores and warehouses, where inventories are mostly back to normal. Hence, the production boost aimed at meeting a huge backlog of demand for goods built up during the pandemic no longer exists. What’s more, the cushion of excess capacity that enabled factories to ramp up production to meet demand is virtually gone. In fact, goods-producing industries are operating at a higher percentage of capacity now than at the peak of the 2010-2019 expansion.
Will the Fed Pivot in Time?
Any hope for a soft landing will depend on how well the pilot, namely the Federal Reserve, is able to bring demand more into balance with the economy’s speed limit, which is poised to lose the temporary influences that pumped up its growth over the past year. The challenge is to determine what level of interest rates would bring about that equilibrium and how long to keep it there. To its credit, the Fed hit the pause button in July to gauge the impact of the previous rate increases, recognizing the lagged effects that still have not played out.
Many borrowers, for example, are still paying the low rates obtained on loans taken out two or three years ago. The lucky ones are homeowners who locked in those rates for up to 30 years.
But people with credit card debt are facing record interest rates on their unpaid balances and delinquencies are rising, particularly among lower-income borrowers. Until recently, pandemic savings helped cover financing costs and were used to pay down a big chunk of outstanding debt. But those savings are mostly depleted even as credit card borrowing has ramped up. Meanwhile, the moratorium on student debt repayments has ended, which will further squeeze the budgets of 40 million borrowers.
Hence, the lagged effects of the Fed’s rate hikes over the past 19 months are starting to kick in, and the drag on consumer spending should become more pronounced in coming months. Whether the setback in retail sales in October is an early sign of the impact remains to be seen. It may well be that consumers took a breather after a torrid spending spree in the third quarter. But with savings diminished and borrowing more costly, households will be relying more on jobs and wages to sustain spending. Both are slowing, which should reinforce the unwinding of pandemic shocks to cool off inflation over time. The risk is that the Fed, which does not see inflation falling to 2% until 2026, will keep rates elevated for too long, leading to a hard landing for the economy. The financial markets are currently pricing in Fed rate cuts starting in the spring, far earlier than the timetable set by policymakers. It’s unlikely that inflation will be much closer to 2% by then, and Fed officials fear easing policy prematurely before inflation is conquered. The economy may adjust to the higher rate environment and stay afloat, but history indicates that once slowing growth starts to drive up unemployment, it is hard to stop and stave off a recession. Hopefully, the Fed will take its foot off the brake in time to prevent history from repeating itself.