What will the Fed do now?

The Federal Open Market Committee meets Sept. 15–16 to determine the direction of interest rates. It can lower the federal funds rate, raise it, or leave it unchanged. What will the Fed do?

President Trump, consumers, and businesses would like to see rates come down. Borrowing costs remain too high for many families to purchase interest-rate-sensitive products, particularly homes.

Businesses also want relief. The bank prime lending rate is approximately 6.75%. That relatively high cost of capital discourages some businesses from borrowing to expand operations, purchasing equipment or hire additional workers. Reducing rates could stimulate investment and accelerate economic growth.

Some Federal Reserve governors may believe that rates should be lower. Others will argue that stubborn inflation leaves the central bank little room to act.

The latest Consumer Price Index rose 0.4% in August and 3.4% over the past 12 months. Core inflation, which excludes food and energy, increased 2.4% over the year. Both measures remain above the Fed’s desired level, although the Fed officially targets inflation as measured by the Personal Consumption Expenditures price index.

Chairman Kevin Warsh recently made his position clear. At Jackson Hole, he said the Fed’s 2% inflation target is “firm” and that the central bank’s predominant focus should currently be on prices.

Does that mean the Fed will raise rates?

Short-Term and Long-Term Rates Are Different

The Fed directly influences short-term interest rates by changing its target range for the federal funds rate. At its June meeting, the committee unanimously left that range at 3.5% to 3.75%.

Long-term rates, however, are determined largely by market forces. They reflect expected inflation, economic growth, government borrowing and the return investors demand for lending their money over many years.

That means a Fed rate cut would not guarantee lower mortgage rates. There have been times when the Fed reduced short-term rates only to see longer-term rates increase.

Suppose an investor wants a real return of 3% on a long-term bond. If inflation is expected to remain at 3%, that investor will seek a nominal return of approximately 6%. If inflation expectations increase, the investor will demand an even higher interest rate.

Consequently, bringing inflation under control may have a greater lasting effect on mortgage rates than a small reduction in the federal funds rate.

If the Fed cuts prematurely and markets conclude that inflation will remain elevated, long-term rates could stay high or even rise. That would defeat much of the purpose of the rate cut.

Energy Is Driving Headline Inflation Higher

Energy prices are an important part of the current inflation problem. The gap between August’s 3.4% headline CPI and its 2.4% core reading indicates how much food and energy are affecting the overall number.

The continuing conflict with Iran has disrupted energy markets and created uncertainty about the future supply of oil. On Sept. 9, West Texas Intermediate crude closed above $97 per barrel, while Brent crude exceeded $109, according to the Energy Information Administration.

Those elevated oil prices eventually spread throughout the economy. They raise gasoline and diesel prices, transportation expenses, airline costs, and the cost of producing and delivering nearly all products consumers purchase.

The Fed cannot produce oil, reopen shipping routes or end a war. Higher interest rates can reduce consumer demand, but they cannot eliminate an energy shortage. Raising rates aggressively in response to a temporary supply shock could slow economic growth without addressing the fundamental source of the price increase.

Still, energy is not the entire inflation problem. Chairman Warsh noted that inflation remains broad enough to require caution. The Fed must determine whether today’s elevated prices represent a temporary wartime shock or the beginning of another persistent inflation cycle.

Considering the available data, the most defensible decision is for the Fed to leave interest rates unchanged.

The economy added 162,000 jobs in August, unemployment remained at 4.1%, and business investment continued to grow. Those figures do not suggest an economy that urgently needs lower rates.

At the same time, inflation remains too high to justify a cut. But because much of the recent increase is connected to abnormal energy prices, raising rates would also be premature.

Holding rates steady would give the Fed time to determine whether energy prices stabilize and whether underlying inflation continues moving toward 2%. Some governors may disagree, but patience appears to be the least risky course.

The more important solution lies outside the Federal Reserve. The United States must help bring the Iran conflict to an end and restore the free flow of oil through world markets. Once the supply disruption ends, crude oil should decline significantly, gasoline prices should follow, and headline inflation should move closer to the Fed’s target.

That would allow market-driven long-term interest rates to decline and give the Fed room to reduce short-term rates.

For now, the Fed should hold steady. End the conflict, restore energy supplies, reduce inflation and then let interest rates come down naturally.

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