Why Won't the Federal Reserve Start Cutting Interest Rates?

Milton Friedman famously taught that monetary policy operates with long and variable lags. By this, he meant that the effects of raising or lowering interest rates should not be expected to occur instantaneously but rather after a long lag.

One of the implications of Friedman’s teaching is that if the Federal Reserve waits for the clearest of signs that the economy is cooling and that inflation is coming down, it likely will have waited too long to avoid a recession. Any interest rate cuts that it makes belatedly will not have the necessary time to arrest the slowing in the economy. This would seem to be particularly the case now at a time when, in addition to causing households and businesses to rein in their spending, the Fed’s high interest rates are damaging the financial system while darkening clouds are gathering over the world economy. 

In recent Congressional testimony, Fed Chairman Jerome Powell acknowledged that the economy is slowing and that the labor market is no longer overheated. Meanwhile, today’s welcome consumer price inflation numbers indicate that inflation is continuing to fall below the Fed’s percent inflation target. Not only did consumer prices actually fall last month, but inflation also came in below economists’ expectations.

As if a slowing economy and cooling inflation were not enough reason for the Fed to cut interest rates, trouble is brewing in the financial system in general and in the regional banks in particular. As a result of the Fed’s 5.25 percentage point hike in interest rates since March 2022, the banks are sitting on more than $1 trillion in mark-to-market losses on their bond and loan portfolios. At the same time, the Fed’s high interest rates are compounding the problems in the commercial real estate sector, which is struggling with record-high vacancy rates as a result of changed work and shopping habits in the wake of the COVID-19 Pandemic.

It seems to have escaped the Fed’s notice that another round of the regional bank crisis could echo the Savings and Loan Crisis of the late 1980s that contributed to the 1990–1991 economic recession. As if to underline this point, a recent National Bureau of Economic Research Study estimates that nearly 400 small and medium-sized banks could fail as a result of their heavy commercial real estate exposure and their interest rate-impaired bond and loan portfolios. 

Yet another reason for the Fed to cut interest rates now is the souring of the world economy. China is in the midst of the bursting of a massive housing and credit bubble. Europe seems to be on the cusp of another sovereign debt crisis as a result of France’s descent into ungovernability and Italy’s remaining on an unsustainable public debt path. Meanwhile, Japan is struggling with an exchange rate that appears to be in freefall.

All of this suggests that the Fed should be cutting interest rates. However, the Fed will be reluctant to do so now ahead of the November election for fear of being accused of being politically motivated. This is a great pity. By the time the Fed eventually acts, the recession train is likely to have long since left the station. 

About the Author: Desmond Lachman 

Desmond Lachman is a Senior Fellow at the American Enterprise Institute, a deputy director in the International Monetary Fund’s Policy Development and Review Department, and the chief emerging-market economic strategist at Salomon Smith Barney.

Image: Shutterstock.com.