Interest rates are too high, the Federal Reserve should cut rates by 50 basis points!

Chief economic commentator Greg Ip of The Wall Street Journal said that given the current situation of inflation and the labor market, the risk of the Federal Reserve cutting interest rates by only 25 basis points this month is greater, and the central bank should cut rates by 50 basis points. Here are his views.

The Fed's interest rate decision this week looks much more difficult than originally thought, but the real issue is not how much to cut, but what the rate should be. The answer is that the rate should be lower, which supports the view of a 50 basis point rate cut.

Last summer, with core inflation well above 3% and an overheated labor market, the Fed was concerned that inflation would remain high and was willing to trigger a recession to prevent this scenario.

Fast forward to now, some key core inflation indicators are below 3%, with some even close to the Fed's 2% target. While the labor market is not cold, it is not hot either.

There are currently not many signs indicating an imminent recession, but waiting for this evidence to appear is risky.

A year ago, the CPI inflation rate was 3.2%, which dropped to 2.5% by August of this year. During this period, the Fed's preferred core PCE dropped from 4.2% to an estimated 2.7%.

The gap between 2.7% and the Fed's 2% target mainly reflects the lagged effects of rising prices for housing, cars, and other items from several years ago. Some alternative indices attempt to exclude these special factors. Harvard economist Jason Furman averaged several indices over different time periods to arrive at a single, PCE-equivalent core inflation rate. In August, this figure was 2.2%, the lowest level since early 2021.

Inflation is likely to continue to decline. Oil prices plummeted from over $83 per barrel in early July to below $70 last Friday. This will directly reduce overall inflation and indirectly lower core inflation, as oil is an input for almost all businesses. Research by Robert Minton, now at the Fed, and Brian Wheaton of UCLA found that oil can explain 16% of the fluctuations in core inflation, with 80% of the impact taking two years to materialize.

Data from the Intercontinental Exchange shows that inflation-protected bonds and derivatives are now forecasting a CPI inflation rate of 1.8% for the next year, with a five-year average of 2.2%.

This is important in two ways. First, it implies that investors are confident the Fed will reach its 2% target. In fact, it suggests a risk of inflation falling below the target, which the Fed should not welcome. Secondly, with the decline in expected inflation rates, real short-term interest rates have risen to between 3.2% and 3.5%.

By any measure, this is contractionary. Fed officials believe the "neutral" real interest rate is between 0.5% and 1.5%, at least 1.75 percentage points lower than the current level. In 2022, the Fed raised rates by 50 and 75 basis points because its starting point was a deeply negative real rate, far from the neutral rate The same logic should now apply, just in the opposite direction.

Meanwhile, the labor market is rapidly cooling. The unemployment rate rose from 3.5% in July 2023 to 4.3% a year later, causing panic, as historically, such an increase signaled a recession in the United States. This is a false alarm. Consumer spending, unemployment insurance claims, or the U.S. stock market have not shown any signs of economic trouble, with the unemployment rate dropping slightly to 4.2% in August. However, the data did not indicate any worrisome inflation pressures.

The Federal Reserve is always risking doing too much or too little. The question is, which is worse? A 50 basis point rate cut is not without risks. Long-term U.S. bond yields could further decline, pulling down mortgage rates. The U.S. stock market could become frothy.

Inflation could also prove to be more stubborn or even rise further, especially if oil prices rebound or tariffs increase. If this happens, the response should be clear: no more rate cuts, rates will remain elevated.

However, only cutting rates by 25 basis points appears riskier. One reason for the decline in oil and other commodities like copper is that the global economy does not look very healthy. Increasing auto loans and credit card delinquencies suggest higher rates are having an impact. The yield curve inversion is because the market believes rates should be lower.

The Federal Reserve has been inclined towards gradual action. In hindsight, given the soft job market and moderate inflation data, the Fed should have cut rates in July. If the Fed only cuts rates by 25 basis points now, and more soft data emerges, it will be even further behind the curve