The market is focused on inflation, but a deteriorating job market combined with high real rates could trigger a disinflationary spiral. Because the Fed is scarred by recent inflation, its response will be too slow, increasing the disproportionate chance that rates on the front end will have to return to zero to combat the downturn.
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The Federal Reserve is tightening policy just as forward-looking inflation indicators are pointing towards a significant decline. This pro-cyclical move, reacting to lagging data from a peak inflation print, is a "classic Fed error" that unnecessarily tightens financial conditions and risks derailing the economy.
The Federal Reserve's anticipated rate cuts are not merely a response to cooling inflation but a deliberate 'insurance' policy against a weak labor market. This strategy comes at the explicit cost of inflation remaining above the 2% target for a longer period, revealing a clear policy trade-off prioritizing employment over price stability.
The Federal Reserve cut rates despite inflation remaining above the 2% target. This action suggests a strategic shift towards tolerating slightly higher inflation—a "soft target" around 2.8%—to prevent the non-linear, snowballing effect of rising unemployment, which is much harder to reverse once it begins.
Despite conflicting inflation data, the Federal Reserve feels compelled to cut interest rates. With markets pricing in a 96% probability of a cut, failing to do so would trigger a significant stock market shock. This makes managing market expectations a primary driver of the policy decision, potentially overriding pure economic rationale.
AI is creating a secular trend of higher productivity but lower labor demand, leading to a 'jobless recovery' and structurally higher unemployment. This consistent threat to the Fed's maximum employment mandate will compel it to maintain dovish monetary policy long-term, irrespective of political pressures or short-term inflation data.
The Federal Reserve is prioritizing labor market stability by cutting rates, fully aware this choice means inflation will remain above its 2% target for longer. This is a conscious trade-off, accepting persistent inflation as the price for insuring the economy against significant job losses.
While consumers might see 0% inflation as perfect, economists consider it dangerous because it is perilously close to deflation. Deflation can cripple an economy by encouraging consumers to delay spending and increasing the real value of debt, making it a state to be actively avoided.
Despite nominal interest rates at zero for years, the 2010s economy saw stubbornly high unemployment and below-target inflation. This suggests monetary policy was restrictive relative to the era's very low "neutral rate" (R-star). The low R-star meant even zero percent rates were not stimulative enough, challenging the narrative of an "easy money" decade.
The current economic cycle is unlikely to end in a classic nominal slowdown where everyone loses their jobs. Instead, the terminal risk is a resurgence of high inflation, which would prevent the Federal Reserve from providing stimulus and could trigger a 2022-style market downturn.
The Fed faces a catch-22: current interest rates are too low to contain inflation but too high to prevent a recession. Unable to solve both problems simultaneously, the central bank has adopted a 'wait and see' approach, holding rates steady until either inflation or slowing growth becomes the more critical issue to address.
