MNI INTERVIEW: Fed Could Cut By Spring As Real Rates Rise

A steady decline in U.S. inflation is jacking up real borrowing costs in a way that could force the Federal Reserve to start cutting interest rates by spring, former IMF economist Brett House told MNI.

Real rates will climb even further If inflation expectations move down as actual headline inflation keeps falling, he said.

"That is an argument for cutting in the spring to do no more than keep real rates where they're at or prevent them from increasing further," he said. "The more inflation expectations fall, the greater the imperative is to push nominal rates down."

Rate cuts in the first half of next year would also be in line with the last few decades of monetary policy history where the last rate hike has been followed by a rate cut within about six months, said House.

"That would be entirely consistent with the turnaround from past hiking episodes. It would also be warranted on the basis that real rates are the highest in decades and it could push the economy through the soft landing into a hard landing recession," he said. The Fed last hiked its policy rate in July, having boosted the fed funds rate from essentially zero to a 22-year high range of 5.25-5.5% over the course of 16 months.

While recent data is consistent with a soft landing, that outcome could be contingent on the proper calibration of monetary policy, House said.

"The challenge now is that if the Fed continues to keep monetary conditions as tight as they are with real interest rates as high as they are, there is a material risk that we will move through this soft landing that has been threaded and onward to a hard landing," he said. "If we see over the next couple of months core inflation come down substantially, conditions for a rate cut become much more likely." (See: MNI POLICY: Fed Likely Done Hiking, Focused On Length Of Hold)

UNDERLYING PRICE PRESSURES

There's also a possibility, however, that the last mile of inflation declines to the Fed's 2% target will prove more difficult and bumpy, said House. An argument for "a little longer pause before beginning cutting rates are those underlying price pressures in core inflation measures that remain relatively strong, that markets have discounted earlier than the Fed's dot plot has implied would be the case," he said.

"I don't think that the Fed has discounted the importance of those underlying core pressures quite as much. The number of rate cuts that we see in 2024 is wholly contingent upon how we continue to see progress in bringing down core inflation."

Higher GDP growth is not a problem for the Fed and is not likely to need either further rate hikes or staying on hold for longer, said House, who spent nearly a decade at the Fund. "But if we see that higher growth is not being generated by higher labor market force participation or better productivity numbers, then it may become more of a concern with a push back on the Fed cutting early."

The Fed in two weeks will also have to address financial conditions after placing greater emphasis on it at the November meeting, he said. Conditions have since eased considerably in the intermeeting period but the Fed is expected to keep interest rates in a range of 5.25% to 5.5% at its next meeting.

"It's unlikely that the easing in financial conditions would tip the Fed toward another rate hike but the loosening and financial conditions on the order of what we've seen, is likely to keep the Fed on hold for longer than it might have otherwise done," said House, now at Columbia Business School.