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Forecasting Interest Rates

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Last week, I explained why the Federal Reserve (Fed) is unlikely to meet its 2% inflation target in 2024, and I haven’t changed my mind. I referred to an article that said, “Fed Chair Jerome Powell made it clear Tuesday he thinks the Fed will need more than a quarter’s worth of data to really make a judgment on whether inflation is steadily falling towards 2%.”

Based on that, I concluded, “If that is the case, and taking Powell’s statement at face value, interest rate cuts seem unlikely in 2024.”

Should we take Powell’s statement at face value?

I am more confident predicting the inflation rate through the end of the year than I am predicting interest rates. Inflation is the result of millions of people deciding what they want to charge for what they sell and what they are willing to pay for what they buy. Monetary policy is the primary determinant of inflation, but today’s inflation results from past monetary policy. Interest rates are heavily influenced by the decisions of a few people at the Fed.

Economics offers much insight into how people will respond to monetary policy in the recent past. However, it offers only a little insight into Powell and his colleagues at the Fed’s decisions.

If inflation does not meaningfully decline, then, taking Powell’s statement at face value, there will be no interest rate cuts in 2024. However, Fed decisions may have political motivations behind them. If so, in an election year, interest rate cuts could be coming even if inflation remains at (or above) its present level.

Economics does lend some insight into this, noting the possibility of political business cycles. The theory, in brief, is that incumbents are more likely to be reelected when the economy is in an upswing, so they have an incentive to stimulate the economy leading up to an election, even if negative consequences of that stimulus will occur after the election.

That stimulus might occur through fiscal policy. For example, an incumbent might introduce a policy to forgive the debts of a group of debtors, which would have the dual effects of injecting additional spending into the economy and buying the gratitude of those whose debts are forgivenRelated to today’s topic, the stimulus also might occur through monetary policy. The Fed can lower interest rates to provide stimulus, even though that would be counterproductive to its declared goal of lowering inflation.

If I am right that the inflation rate will show no meaningful decrease in 2024, and the Fed does not cut interest rates, then Powell’s statement means what it says. If inflation does not fall and the Fed cuts interest rates, that would be a sign that it is bowing to political pressure from incumbents to provide monetary stimulus to the economy prior to the election.

We can see what the Fed is doing. Intuiting its motives is conjecture. I have previously suggested that Powell’s Fed has been politically astute in its anti-inflation policies. In 2022, Powell and others at the Fed echoed the Biden administration’s line on inflation even though there was good reason to question it.

If my conjecture two years ago was correct, we might expect interest rate cuts leading up to the election, regardless of the inflation numbers.

Last week, I gave an inflation forecast. This week, I am telling you that I cannot forecast short-term interest rates because that is up to the Fed’s discretion, and I can’t read their minds. What I will say is that if my inflation forecast proves accurate and the Fed lowers interest rates prior to the election, there is good reason to think that the Fed’s “get tough on inflation” policy was put on hold for political reasons.

The post Forecasting Interest Rates appeared first on The Beacon.

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