MNI INTERVIEW: Swift Inflation Decline To Prompt Early Fed Cut

Fast-falling inflation raises the concern the U.S. is switching back to a pre-pandemic low-inflation regime, a downside risk that will prompt the Federal Reserve to begin lowering interest rates rapidly starting March, former New York Fed and IMF economist Dominique Dwor-Frecaut told MNI.

The six-month annualized PCE inflation rate, a measure cited by Fed officials in recent weeks, has seen a rapid decline to 2.0% since early last year, while the corresponding core rate has dipped to 1.9%.

Plummeting rents on newly signed leases over the past year also suggest more housing disinflation in the pipeline. Much lower inflation would mean real interest rates are likely overly restrictive, Dwor-Frecaut said. The current nominal fed funds rate is roughly 2.5 percentage points above the Fed's estimate of its longer-run rate.

"From the 1970s until now, either inflation is very high or low, below 2%," she said in an interview. "The Fed doesn't like low inflation any more than they like high inflation. I have a strong conviction that they cut 25 basis points in March, and 50 is not out of the picture" if inflation falls much faster or the labor market deteriorates.

LOW-INFLATION REGIME

The FOMC is expected to maintain its fed funds rate target at 5.25%-5.5% at its meeting Wednesday and shift to more neutral guidance on future rate moves in preparation for easing later this year. Many former Fed officials have told MNI they expect officials to wait until May or June to begin dialing back rates, but Dwor-Frecaut and some others say the inflation data will prompt an earlier start. (See MNI INTERVIEW: Taylor Rule Supports March Cut -Ex-Fed's Tracy)

As few anticipated the pandemic-era surge in inflation, Fed officials have also been surprised by how quickly it's declined over the past year. A Bank of International Settlements paper last year presented an alternative view of the inflation process as two regimes -- low and high -- with prices behaving very differently in each period.

Lower energy prices account for three-quarters of the disinflation seen so far with the unanticipated expansion in labor supply driving the rest, and those trends are set to continue, said Dwor-Frecaut, now senior macro strategist at Macro Hive. The Fed gets credit for keeping inflation expectations stable, but now the risk is growing that policy is too tight.

"Normalization makes sense. Inflation is below target and they're far from their long-term target on the fed funds rate. I don't think they'll tell us we're worried inflation might undershoot, because that could get incorporated in market expectations and become self-fulfilling."

FRONTLOADING

Once cuts begin, the Fed could move faster than markets expect, in large part because policymakers want to avoid making policy changes in the run-up to the U.S. presidential election, Dwor-Frecaut said.

"They want to stay away from the worst of the election season. The party conventions are in July and August. They want to do a lot of cuts in the first half. Frontloading is very important both from a macro perspective and to avoid getting caught up in politics."