Fed’s Major Rate Cut Gamble Poses Risks of Policy Error and Inflation Resurgence

The Federal Reserve’s recent decision to kick off its rate-cutting cycle with a significant reduction in September raises concerns about a potential policy mistake, especially given the prevailing strong demand that could reignite inflationary pressures.

According to MRB Partners, there is a risk that the Fed may need to reverse its rate cuts later this year or in 2025, reminiscent of the policy misstep seen in 2021. This caution comes amidst concerns that the Fed may be underestimating the current strength of the economy and inflation.

On September 18, the Fed implemented a 50 basis point rate cut, initiating its easing cycle—the first such reduction since March 2020. They also indicated the possibility of two additional 25 basis point cuts this year and a further percentage point reduction in the following year.

MRB Partners highlighted that this substantial cut was “highly unusual” when compared to previous rate-cutting cycles, during which the National Bureau of Economic Research’s business cycle indicators were displaying much weaker trends.

Fed Chair Jerome Powell’s statement that “the U.S. economy is in good shape” and that the labor market is in a “strong place” appears to contradict the decision to enact such a large cut, according to the research firm.

This aggressive approach may be premature, given the resilience of the U.S. economy. Consumer spending is robust, bolstered by a strong labor market and increasing real incomes. Several factors could contribute to persistent inflation, including tight labor markets fueling wage growth, ongoing supply chain disruptions, geopolitical tensions affecting commodity prices, and the residual impacts of fiscal stimulus measures.

In this environment of stubborn inflation driven by strong demand, the Fed’s efforts to maintain price stability while simultaneously supporting economic growth may become increasingly challenging.