Time is running out for the Federal Reserve! Delaying rate cuts beyond September would be another policy mistake

The call for the Federal Reserve to cut interest rates as soon as possible seems to be growing. Allianz's chief economist, Adrian, recently warned in an article that if the rate cut is delayed until after September, the Fed's hope for a soft landing may be dashed. The following is the full text.

Two years ago, the inflation rate in the United States soared to over 9%, and is currently around 3%. Based on current trends, the inflation rate is expected to stabilize at 2.5%-3%. Most economists believe that this range meets the requirements for financial stability, including anchoring inflation expectations firmly.

Given signs that the U.S. economy is slowing down faster than many expected, this news should open the window for the Federal Open Market Committee (FOMC) to cut rates at its meeting next week. However, the current mindset of the Fed suggests that it is more likely to only signal a rate cut at the September meeting. It is worth noting that if the Fed fails to cut rates in July or September (which cannot be ruled out), this would constitute another policy mistake for the Fed. Since misjudging inflation in 2021, the Fed has been seeking to restore its credibility.

One reason the Fed is reluctant to cut rates is its lack of confidence that inflation will continue to decline to the 2% target rather than stabilize at the 2.5%-3% level.

Maintaining monetary policy at a restrictive level increases the possibility of achieving the 2% inflation target, but faces significant risks of causing undue harm to employment and the economy.

In fact, it is still unclear whether 2% is the correct inflation target.

The appropriate practices in a world where there has been a series of favorable developments in terms of insufficient total demand and supply are not as suitable in the globally fragmented world. In this world, supply chains are being rewired, and the flexibility of domestic supply continues to decrease.

Nevertheless, after such a long period of forecasting errors and actual inflation rates far exceeding the target, policymakers are unlikely to revise the inflation target.

A more likely approach is for the Fed to gradually reduce the inflation rate to the target level from now on, clearly stating that its policy is now highly sensitive to developments in the labor market.

The pressures and strains felt by low-income families and small businesses have exacerbated the risks of causing undue harm to the economy.

They have depleted their cash reserves during the COVID-19 pandemic, while the cost of servicing heavy debts at this time is much higher. Therefore, they cannot afford the impact of the Fed's overly restrictive policies, especially when the lagged effects of rising interest rates have not been fully absorbed by the economy and the entire financial system.

In recent comments, the Fed has finally begun to pay more attention to the risks facing the labor market, making its assessment of the overall economic situation more balanced.

Policymakers will sooner or later shift further, reflecting their greater concerns about the excessive weakening of employment and economic activity.

The reason this has not happened sooner (similar to the hesitation about cutting rates next week) is because policymakers, after making the significant mistake in 2021 of hastily viewing the rise in inflation as "transitory," have become overly reliant on data in their decision-making Although in the grand scheme of things, waiting until September to cut interest rates is not a big issue, further delay could cause greater concerns. For an institution that lacks confidence and sufficient strategic support, such delays are prone to happen. In fact, all it takes is a negative data surprise in the inevitable noisy high-frequency data.

If the Federal Reserve is not constrained by outdated inflation targets, inappropriate monetary policy frameworks, and a mindset overly reliant on data, the likelihood of an economic soft landing and maintaining American economic exceptionalism will significantly increase.

On the contrary, based on my assessment, this likelihood is only 50%, which is not a reassuring level, especially considering high debt levels, worsening inequality, and a series of non-economic uncertainties facing the U.S. and global economies