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Is a policy mistake buried in the Fed’s plan to cut rates?

By Yasin Ebrahim

Investing.com -- The Federal Reserve took a March rate cut off the table, and welcomed strong economic growth with open arms, ditching its worries about the risk of growth-led inflation, but against a string of data including the blowout January jobs report some question whether rate cuts are needed at all this year.

Fed risks policy mistake as economic strength suggest no rate cuts needed

“I don't think rate cuts are warranted and it could be a policy mistake to cut rates that will have intermediate-term inflationary consequences,” Phillip Colmar, global macro strategist at MRB Partners told Investing.com's Yasin Ebrahim in a recent interview, following the Fed's Jan. 31 decision to keep rates steady and downplay a March cut.

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Rate cuts would likely further stimulate at a time when recent data including the much stronger than expected jobs report in January suggests current Fed policy is accommodative rather than restrictive.

The inflation consequences “may not be revealed in the next couple of months because of the unwinding of inflation prints,” or base effects, and “some of those pandemic-related distortions,” Colmar says, but could likely begin in the second half of this year, post the election cycle as the economy slurps up the rate-cut Kool-Aid.

“The risk of inflation bottoming out higher than people expect will likely reveal a higher underlying trend and that really closes the window on how deep the Fed will cut rates, “Colmar added, expecting that the Fed will stick with its forecast for three cuts, and isn’t likely to give the market the five or six rate currently priced in this for this year.

Colmar isn’t alone in his worries about reaccelerating economic growth giving inflation a new lease of life.

Following the January monthly payrolls reported showing the economy drummed up 353,000 new jobs in January -- up from 333,000 the prior month and confounding economist forecasts for 187,000 – and monthly wage growth jumped to a 0.6% pace, which was double the expectation of 0.3%, Scotiabank’s Derek Holt, Vice-President&Head of Capital Markets Economics, in a Friday note warned that “if this keeps up, we can’t rule out the return of rate hikes.”

But are ‘maintenance cuts’ needed to avoid real rates becoming too restrictive?

Others, however, believe cuts are needed to maintain the level of restrictiveness in the economy because if inflation continues to fall, then the real interest rates, which are adjusted for inflation and reflect the real cost of borrowing, could become far too restrictive and risk a steep decline in the economy.

“By the June meeting, we forecast job gains will be around replacement rates and core inflation will have shown broad slowing that convinces FOMC members progress is sustainable,” Morgan Stanley said, forecasting a first cut in June.

As inflation falls, real rates become more restrictive, and we think gaining consensus to cut will be easier,” it added, noting that Fed Chair Jerome Powell had hinted, in his press conference earlier this week, that a decline in new tenant rents, or NTR, in Q4 could force the Fed to lower its expectations for inflation when it updates its economic projections in March.

"We will update our inflation forecast at the next meeting...it may be lower now given the data we have gotten," Powell said in the FOMC press conference on Jan. 31. This comment, Morgan Stanley believes, refers to “both the incoming inflation data and the NTR data, which participants are likely to include in forecast adjustments.”

Growth goes from potential foe to friend as Fed sets sights on 'immaculate disinflation'

For a long time, stronger economic growth was the boogeyman hiding under the inflation bed, forcing the fed to cling onto its tightening bias. And for good reason. When there are too many jobs, chasing too fewer workers, companies are forced to hike wages to compete in the labor market, and consumer spending ratchets up, keeping economic growth on the up, and up.

“Evidence of growth persistently above potential, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy,” Powell said at the Nov. 1, 2023 FOMC press conference.

But that has all changed. The Fed now believes disinflation, a strong economic and labor market growth can all co-exist -- the "immaculate disinflation" race is truly on.

“I think we look at stronger growth. We don't look at it as a problem. I think, at this point, we want to see strong growth. We want to see a strong labor market. We're not looking for a weaker labor market,” Powell said at a press conference that followed the Jan. 31 FOMC meeting.

This U-turn somewhat in messaging from the Fed has left many puzzled. “I do not have a good explanation for why he sounded more dismissive toward GDP growth this time around,” Holt added.

Do all roads lead to cuts… even stronger economic growth?

Colmar agrees, saying that “it is really going to take weakness in the economy that creates enough weakness in labour and downward pressure on wages,” adding that the increased participation rate, the number of people entering the labor market, that had helped keep a lid on wages, may not have much room to run.

“If you look at the small business sector, which employs the bulk of the population, it's telling you a pretty profound thing right now,” Colmar said. “It’s telling you that inflation is the problem, that small businesses are actually planning to lift selling prices and lift wage compensation or employment compensation … those things aren't good for the Fed,” Colmar added.

Still, with a data-dependent Fed, if the data continue to surprise to the upside, there is a chance that the Powell we saw in November, worries about above potential growth, may return.

“If Q1 GDP tracking continues to be hot, then it may return Powell to what he said in the November press conference when he said ‘Evidence of growth persistently above potential or that labour markets are not coming into balance could warrant further tightening,’ Holt added.

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