The Fed may make a mistake that undermines the economy if it doesn’t cut interest rates now

The Federal Reserve should cut interest rates. Now. The central bank’s current higher-for-longer interest rate strategy — steadfastly holding the federal funds rate that’s directly controlled by the Fed at a high 5.5% — threatens to undermine the economy.

And to what end? Policymakers have already effectively achieved their goals. The economy is operating at full employment, evidenced by the 4% unemployment rate, and the Fed’s 2% inflation target is in clear view as inflation continues to moderate.

Many other central banks have begun cutting rates, including the European Central Bank, Bank of Canada, and Swiss National Bank, but not the Fed.

Behind the Fed’s reticence to cut rates is its uncertainty about whether inflation will return to target in a timely enough way. A bump in inflation at the start of the year was too much for Fed officials to dismiss, even though it appears largely to have been the result of various measurement issues. Shelter prices have been a key pain point, particularly so-called owners’ equivalent rent, the hypothetical price homeowners would pay to live in their house.

They may be trying to make up for the past after waiting too long to raise rates when inflation took off in 2021 due to the global supply chain and labor market disruptions caused by the pandemic. Then in 2022, inflation accelerated with the Russian invasion of Ukraine and spikes in oil, natural gas, and agricultural prices.

Policymakers now appear frantic to achieve their inflation target and willing to take the chance that they keep rates too high for too long and undermine the economy.

The presidential election further complicates the Fed’s decision-making. While officials would never say so, it is reasonable to think they are nervous about being politicized by former President Donald Trump. In his first term, the former president was openly critical of Fed policy and Fed Chair Jerome Powell, and recent credible reports suggest Trump advisers are contemplating steps he might take to influence or determine the setting of interest rates in a second term. There is a not-inconsequential possibility that Trump would work to impede the independence of the Federal Reserve and the conduct of monetary policy.

While this concern may not be enough to forestall a rate cut before the election, it may raise the bar for one. That is, the inflation numbers would have to be near picture-perfect in the next few months before the Fed would lower rates.

They likely also take comfort in the economy’s remarkable resilience to date amid the higher interest rates and expect that resilience to continue. Most households and businesses did an admirable job of locking in record-low rates during the pandemic and have not suffered significant increases in their debt payments despite today’s much higher rates.

There are a host of other reasons to think the economy will be able to gracefully weather the higher rates, but the longer rates stay where they are, the greater the risk that they expose fissures in the economy and a very different dark scenario unfolds.

Last year’s banking crisis is a good example of this. The Fed’s aggressive rate hikes hammered the value of the banking system’s bond holdings, ultimately causing several good-size banks to fail and ignite a shocking widespread bank run. The Fed was forced to set up a temporary fund for the banks to borrow from, using their securities valued at par as collateral, to replace the deposit outflow. The FDIC also extended deposit insurance to all depositors in failing institutions, ignoring the $250,000 deposit insurance limit.

It is difficult to identify what might break next in the financial system under the pressure of the Fed’s higher-for-longer strategy, but it might be even harder for policymakers to patch up the system if it breaks again.

Last year’s rash of layoffs in the technology industry is another good case in point. The Fed’s aggressive rate hikes set off a sharp correction in the stock market, particularly of technology stocks with outsize price-earnings multiplies. The tech companies responded by slashing payrolls and their more speculative investments.

While the promise of artificial intelligence has since turned things around for many of these companies and their stocks, the episode shows how fast companies are able and willing to swing from rapid staffing-up to cutting back. Businesses’ seeming reticence to lay off workers has been critical to the economy’s resilience, but their resolve may be more tenuous than thought.

Odds are rising and already uncomfortably high that the Fed will make a mistake that undermines the economy. Global investors expect the Fed’s first quarter-point interest rate cut to be in September. But this higher-for-longer strategy risks rates being too high for too long. If Fed officials are simply able to do no harm, the economy will continue to perform well and land softly. But it is reasonable to fear that they cannot help themselves.