The Federal Reserve is widely expected to leave interest rates unchanged at the conclusion of its meeting on Wednesday, but investors will be watching closely for any hint at when and how much it might lower those rates this year.
The expected rate cuts raise a big question: Why would central bankers lower borrowing costs when the economy is experiencing surprisingly strong growth?
The United States’ economy grew 3.1 percent last year, up from less than 1 percent in 2022 and faster than the average for the five years leading up to the pandemic. Consumer spending in December came in faster than expected. And while hiring has slowed, America still boasts an unemployment rate of just 3.7 percent — a historically low level.
The data suggest that even though the Fed has raised interest rates to a range of 5.25 to 5.5 percent, the highest level in more than two decades, the increase has not been enough to slam the brakes on the economy. In fact, growth remains faster than the pace that many forecasters think is sustainable in the longer run.
Fed officials themselves projected in December that they would make three rate cuts this year as inflation steadily cooled. Yet lowering interest rates against such a robust backdrop could take some explaining. Typically, the Fed tries to keep the economy running at an even keel: lowering rates to stoke borrowing and spending and speed things up when growth is weak, and raising them to cool growth down to make sure that demand does not overheat and push inflation higher.
The economic resilience has caused Wall Street investors to suspect that central bankers may wait longer to cut rates — they were previously betting heavily on a move down in March, but now see the odds as only 50-50. But, some economists said, there could be good reasons for the Fed to lower borrowing costs even if the economy continues chugging along.
Here are a few tools for understanding how the Fed is thinking about its next steps.
Inflation will factor into Fed thinking.
The central bank will not release fresh economic projections at the meeting on Wednesday, but Jerome H. Powell, the Fed chair, could offer details about the Fed’s thinking during his news conference after the 2 p.m. policy decision.
One topic that he is likely to discuss is the all-important concept of “real” rates — interest rates after inflation is subtracted.
Let’s unpack that. The Fed’s main rate is quoted in what economists refer to as “nominal” terms. That means that when we say interest rates are set around 5.3 percent today, that number is not taking into account how quickly prices are increasing.
But many experts think that what really matters for the economy is the level of interest rates after they’re adjusted for inflation. After all, investors and lenders take into account the future purchasing power of the interest that they will earn as they make decisions about whether to help a business expand or whether to give out a loan.
As price pressures cool, those economically relevant real rates rise.
For example, if inflation is 4 percent and rates are set to 5.4 percent, the real rates are 1.4 percent. But if inflation falls to 2 percent and rates are set to 5.4 percent, real rates are 3.4 percent.
That could be key to Fed policy in 2024. Inflation has been slowing for months. That means that even though rates today are exactly where they were in July, they’ve been getting higher in inflation-adjusted terms — weighing on the economy more and more.
Increasingly steep real rates could squeeze the economy just when it is showing early signs of moderation, and might even risk setting off a recession. Because the Fed wants to slow the economy just enough to cool inflation without slowing it so much that it spurs a downturn, officials want to avoid overdoing it by simply sitting still.
“Their goal right now is to keep the soft landing going,” said Julia Coronado, founder of MacroPolicy Perspectives. “So why risk tightening policy? Now the challenge is balancing risks.”
The neutral interest rate is key.
Another important tool for understanding this moment in Fed policy is what economists call the “neutral” interest rate.
It sounds wonky, but the concept is simple: “Neutral” is the rate setting that keeps the economy growing at a healthy pace over time. If interest rates are above neutral, they are expected to weigh on growth. If rates are set below neutral, they are expected to stoke growth.
That dividing line is tough to pinpoint in real time, but the Fed uses models based on past data to ballpark it.
Right now, officials think that the neutral rate is in the neighborhood of 2.5 percent. The Fed funds rate is around 5.4 percent, which is well above neutral even after being adjusted for inflation.
In short, interest rates are high enough that officials would expect them to seriously weigh on the economy.
So why isn’t growth slowing more markedly?
It takes interest rates time to have their full effect, and those lags could be part of the answer. And the economy has slowed by some important measures. The number of job openings, for instance, has been steadily declining.
But as consumer spending and overall growth remain hearty, Fed officials are likely to remain wary that rates might not be weighing on the economy as much as they would have anticipated.
“The last thing they want to do here is declare mission accomplished,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. “I think they’re going to be very cautious about how they communicate this — and I think they have to be.”
The Fed is likely to proceed carefully.
The question is how the Fed will respond. So far, officials have suggested that they are not willing to completely ignore quick growth, and that they want to avoid cutting rates too early.
“Premature rate cuts could unleash a surge in demand that could initiate upward pressure on prices,” Raphael Bostic, president of the Federal Reserve Bank of Atlanta, said in a speech on Jan. 18.
At the same time, today’s strong growth has come when productivity is improving — companies are producing more with fewer workers. That could allow the economy to continue expanding at a brisk pace without necessarily pushing up inflation.
“The question is: Can this be sustained?” said Blerina Uruci, chief U.S. economist at T. Rowe Price.
Ms. Uruci doesn’t think that the strong economy will prevent Fed officials from beginning rate cuts this spring, though she thinks it will prod them to try to keep their options open going forward.
“They have the advantage of not having to pre-commit,” Ms. Uruci said of the Fed. “They need to proceed cautiously.”
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