Cutting interest rates is misguided - the easy money would only fuel inflation

By Peter Morici

The Federal Reserve should keep credit conditions tight for now

Federal Reserve Chair Jerome Powell is too focused on when to cut interest rates. First, it's uncertain that U.S. inflation will head back to 2% and stay there, and second, Powell isn't giving enough consideration to the hemorrhaging federal deficit.

The Congressional Budget Office projects the U.S. deficit will be 5.6% of GDP this year. That's up from 4.6% in 2019, the last full year before the COVID-19 pandemic and inflation's surge. By 2025, the deficit is predicted to jump to 6.1% of GDP. The difference from 2019 will raise the demand for goods and services by half a trillion dollars.

CBO projections assume federal policies will remain unchanged, but neither President Joe Biden nor former President Donald Trump are inclined toward fiscal restraint.

Biden's proposed 2025 budget includes boosts for federal assistance for pre-K education, childcare, tax credits for working families and many other initiatives, for example. To fund these with higher taxes on businesses and families earning more than $400,000, Democrats need to win the House and hold the Senate, but the Senate electoral map this cycle heavily favors the GOP.

Trump, if elected, would like to cut corporate taxes and partially fund that by raising tariffs on imports, but tariffs are not raised as much as they are touted. Too many products from China can't be quickly sourced elsewhere, and we can count on lots of exceptions and lost revenue.

The Fed is boxed in

Powell has repeatedly said he won't lower interest rates until the Fed is confident that the "inflation rate is moving sustainably down toward 2%." But we can't be confident until we hit that target and several months pass so we know that inflation is tamed.

In 2021, the Fed and Biden administration expressed confidence that inflation was transitory, which proved false. Economists and other prognosticators have been terribly poor at forecasting the post-COVID economy.

An IMF study of efforts to curb inflation in 40 countries indicates that longer-term growth performance is better when central banks refrain from cutting interest rates too soon and kill the inflation dragon properly before focusing again on growth.

Hampering the Fed's inflation goal is that the U.S. economy is adding unanticipated new capacity. The recent surge in immigration has significantly increased the labor force and has not much depressed wages. Immigrants bring skills that are in short supply and complement domestic workers, making them more productive. Some fill jobs that native-born Americans would prefer not to do.

Additional workers earning paychecks add to demand in the economy and require more public services. Those waiting for work permits require assistance with shelter and subsistence.

Together, these considerations suggest that delaying interest rate cuts is more appropriate for the U.S. than pushing ahead.

How not to tame inflation

Lowering interest rates would likely stoke inflation. The construction sector offers a good example of what could happen. The Biden administration is making historic investments in manufacturing - from electric vehicles and batteries to semiconductors - and these are fueling a boom in new factory construction.

Another inflationary catalyst is artificial intelligence, which is channeling investment into technology and a creating an entirely new industry, from the chips designed by Nvidia (NVDA) and its competitors to cloud computing infrastructure and software applications from the likes of Microsoft (MSFT) and Alphabet (GOOG) (GOOGL).

These developments create capital market conditions quite different from those that prevailed during the years between the global financial crisis and the pandemic shutdown, when interest rates were kept quite low with little inflation.

In those years, capital was cheap and a lot of money was lent to prop up firms with sub-investment-grade bond ratings. Now those businesses are scurrying to refinance debt in a higher interest rate environment.

In addition, capital is being redirected to battery and semiconductor plants, AI investments and other projects that could genuinely improve the productivity of the U.S. economy and living standards.

Lowering interest rates would finance both the failing firms and those with promise, and further heat up the U.S. economy. So for now, at least, Chair Powell, leave interest rates where they are.

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

-Peter Morici

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04-20-24 1111ET

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