MNI INTERVIEW: Fed Done Hiking, Will Cut As Soon As Q1-Tilley

The Federal Reserve is likely done raising interest rates and will need to reduce them sooner than policymakers indicated in their September forecasts – perhaps as early as the first quarter as growth proves weaker than expected, former Philadelphia Fed economic advisor Luke Tilley told MNI.

“They don’t need to hike rates anymore. Inflation is slowing incredibly quickly,” Tilley said in an interview. (See MNI POLICY: Softer Trend Inflation Boosts Case For Fed Pause)

He said Fed estimates for core PCE to end the year at 3.7% are too high because they would require the monthly gain to accelerate back to a 0.3% pace, adding that recent worries about growth picking up speed again are based on backward-looking data. As disinflation proves more persistent, the Fed will need to adjust course, said Tilley, now chief economist at Wilmington Trust.

“They absolutely need to reduce rates as inflation is falling. If they just leave them where they are, that’s a tightening as well,” said Tilley, echoing comments by Fed Chair Jerome Powell and other top officials on the need to focus on inflation-adjusted interest rates.

The Fed has raised rates aggressively over the past 18 months but held them steady at its most recent meeting in September. FOMC members penciled in another increase for this year but a recent spike in long-term bond yields is making that less likely by tightening financial conditions.

CUTS AS EARLY AS Q1

Importantly, the Fed’s SEP also reduced the number of rate cuts for 2024 to just two from four, emphasizing policymakers “higher for longer” mantra.

“I think they will end up reducing rates before they are saying, but it’s also true that they need to keep up the tough talk to make sure financial conditions don’t loosen and they need to be risk-averse in a real sense because they want to be sure inflation is coming down,” Tilley said.

“It’s my opinion that they will be doing that by the middle of next year and maybe even the first quarter," he said, "When they need to cut, they will start cutting to 4-½, 3-½ that’s still having their foot on the brake.”

A recent “growth scare” that raised fears monetary policy is not dampening demand sufficiently to bring down inflation is misplaced, he said.

“They’re still worried about these growth numbers and that’s what the rise in yields is about, it’s about being worried about strong growth and the Atlanta Fed GDP (measure) running at about 5% and none of that is real, we don’t have an economy that’s that strong,” Tilley said. “It’s running between 1 and 2%, capex has weakened the consumer is slowing. I think once those fears dissipate yields will be coming down.”

That said, Tilley also doesn’t think the economy is going to crash, saying he sees a 65% probability of a soft landing.

TOLERATING ABOVE-TARGET INFLATION

The Fed would be reluctant to raise its inflation target but would probably display a certainly leniency about the timeframe over which it foresees a return to the 2% inflation target, he said. (See MNI POLICY: Fed To Consider Shift To Inflation Target Band)

“I think that there is a tolerance for that. It makes it really uncomfortable for them to talk about it in those terms. But if inflation running at 2.5% or 3% and if you have a strong economy that doesn’t look like it’s going to significantly move to the upside, there’s no real reason to get very aggressive to get those last 50 basis points off,” Tilley said.

“You’ll more likely than not to miss to the side of being too stringent and hurt the employment side of the mandate.”