Mark Lister: Did the Fed just make a policy mistake leaving interest rates unchanged?

Jerome Powell, chairman of the US Federal Reserve. Photo / Getty Images

Mark Lister is investment director at Craigs Investment Partners.

OPINION

THREE KEY FACTS

• The US Federal Reserve has kept interest rates unchanged but may cut them in September.
• The unemployment rate rose to 4.3%, triggering concerns about a potential recession.
• Economist Claudia Sahm downplays recession fears, citing factors like high immigration and pandemic effects.

The US Federal Reserve left interest rates unchanged at its meeting several days ago.

However, it left financial markets in no doubt that a cut is imminent, chair Jerome Powell noting one might be on the table at the next meeting in September.

But will that prove too late, and did the Fed just make a mistake by not cutting when it had the chance?

After all, inflation increasingly looks to be under control in the US.

The Feds’ preferred inflation gauge is tracking at an annual pace of 2.5%, the lowest since March 2021 and just half a per cent above its target.

The annualised three-month average has fallen to just 1.6%, with forward indicators suggesting the disinflationary trend will continue.

This progress can already justify a first cut, especially when one considers the lags in monetary policy.

A “soft landing” is always the goal when a central bank embarks on an interest-rate hiking cycle to knock inflation on the head.

That generally means getting price increases under control without causing a recession or major economic slowdown in the process.

To achieve it, policymakers need to ensure unemployment doesn’t rise too much, even though they’re actively trying to constrain activity.

It’s a difficult needle to thread, and central banks have a mixed track record.

There are a few exceptions, such as the US hiking cycles of 1984 and 1995, but most of the time when interest rates rise sharply, a recession follows.

A key to success is getting the timing of the eventual easing cycle right, and that’s no easy task.

Cut too early and you appear soft on inflation, potentially risking a reacceleration. Cut too late and the economy will suffer more than is necessary, increasing the likelihood of a recession.

Right now, it’s the latter which is worrying investors.

Those concerns came into sharper focus in the days following the Fed’s decision, after a string of weaker economic data, particularly the July jobs report.

We saw a surprise jump in the unemployment rate to 4.3%, the highest since October 2021 and well above the 54-year low of 3.4% from early last year.

That triggered a closely-watched economic indicator called the “Sahm Rule”, named after economist Claudia Sahm.

A recession isn’t upon us, but the risks of one are increasing, writes Mark Lister. Photo / 123rf

It purports that if the three-month average of the unemployment rate rises half a per cent above its low from the prior 12 months, the US economy is in recession (or close to it).

There’s never been a time this has happened since 1945 without a recession occurring, and the Sahm rule has never given a false signal.

With a 100% hit rate across the past 12 recessions, you can see why investors took notice.

Despite the impressive record, this doesn’t guarantee a US recession is on the cards.

Sahm came up with this in 2020, when she was working at the Fed.

It wasn’t intended as a forecasting tool, but one to help policymakers act more quickly and send out stimulus checks automatically.

She’s downplayed the recession talk in recent days, pointing out that high immigration and lasting aftershocks from the pandemic may have distorted the unemployment numbers slightly.

However, the Fed should take note.

Inflation is headed toward its target, and cracks are appearing across the economy.

A recession isn’t upon us, but the risks of one are increasing.

To improve its chances of threading the needle, the Fed should’ve probably cut at that last meeting rather than waiting until later in the year.

Let’s hope that doesn’t prove to be a policy mistake it regrets.

Mark Lister is investment director at Craigs Investment Partners. The information in this article is provided for information only, is intended to be general in nature, and does not take into account your financial situation, objectives, goals, or risk tolerance. Before making any investment decision Craigs Investment Partners recommends you contact an investment adviser.