The Fed’s Been Wrong About the Economy for Years
The Federal Reserve’s rate-cutting cycle has very likely come to an end—although it may take Fed officials several months to figure this out.
The Fed last hiked its overnight benchmark way back in July of 2023, when it raised the federal funds target to a range of 5.25 percent to 5.50 percent. At the time, the Fed was convinced that this level of interest rates would weigh heavily on economic growth, bringing the economy close to a recession or at least a long period of sluggish growth.
The summary of economic projections (SEP) released at the prior Fed meeting in June of 2023 showed that officials expected the economy to grow just one percent in 2023 and 1.1 percent in 2024. By 2025, growth was expected to creep up to 1.8 percent, which also happens to be the Fed’s long-run estimate of growth for the U.S. economy.
The Fed was also expecting unemployment to rise rapidly. In the summer of 2023, the unemployment rate was hovering around 3.6 percent. The June projections showed that officials expected it would rise to 4.1 percent by the end of the year, which was basically a prediction that the Sahm rule recession indicator would be triggered. This was actually more positive than they had been in March, when the projections showed end of 2023 unemployment at 4.5 percent. For the following year of 2024, unemployment was projected to rise to 4.5 percent and then stay there in 2025.
You can see why this made Fed officials nervous. Bringing growth down to one percent would have meant that a slight hiccup in the economy might push it into contraction. The projected rise in the unemployment rate would have meant a rise in financial hardship and would definitely have felt like a recession to a lot of Americans.
Oops Isn’t a Monetary Policy
Of course, the Fed got all this wrong. The economy grew 2.9 percent from the fourth quarter of 2022 to the fourth quarter of 2023, nearly three times the growth the Fed was projecting halfway through the way. This year, growth is likely to come in at a very similar pace, far better than the 1.1 percent projected. Unemployment at the end of 2023 was 3.8 percent, and it was just 4.1 percent at the end of last year.
In other words, the Fed’s interest rate policy just did not weigh as heavily on growth or employment as Fed officials expected.
Somehow, however, the Fed failed to learn this lesson. When it started cutting rates in September, it was expecting economic growth in the second half of 2024 to turn very sluggish and the unemployment rate to climb to 4.4 percent and stay there through next year. Statements by Fed officials made it clear that they believed that their predictions of a softening in the labor market were finally about to come true.
The recent economic data has made it clear that the Fed began cutting when it was still too pessimistic about growth and employment. According to the December projections, Fed officials now see the economy as having grown 2.5 percent in 2024. They also projected unemployment would hit 4.2 percent—which has already been shown to be too high after the stronger than expected jobs report released last week.
In December, the Fed was projecting that the federal funds rate would be cut to a range of 3.75 to four percent in September, the equivalent of two more cuts. The market now gives that less than a one-in-three chance of occurring. There’s a 40 percent chance of just one cut and a 30 percent chance of no more cuts at all.
No More Cuts
We expect that the Fed will not cut again this year. Indeed, it is likely that the Fed’s next move will be a rate increase as it becomes clear that jobs are less vulnerable to monetary policy than thought and inflation has become stuck at a level inconsistent with the Fed’s two percent target.
That doesn’t mean that we expect rate hikes soon. Many officials still see current rates as restrictive and believe that they have more room to bring them down. It will probably take several months of strong jobs reports and stubborn inflation to convince the Fed of the depth of its mistake when it started cutting in September. But the talk among investors is very likely going to shift to when rate hikes are coming and what it will take to trigger higher rates.
Certainly, the bond market appears to agree that the era of Fed cuts is over. We expect that the 10-year Treasury will go above five percent this year as investors become convinced that the Fed’s next move will be a hike instead of a cut.
What would it take to trigger a hike sooner rather than later? Probably a combination of rising inflation expectations and a rise in the personal consumption price index to three percent or higher. Short of that, it’s likely to be a slow march toward an inevitable Fed hike.
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