In the macroeconomic landscape, the Federal Reserve (the Fed) has been swiftly increasing the Fed Funds rate, reaching a significant 5.25%, a level last seen in 2007. However, the circumstances are different now compared to that time. In 2007, there was less financial leverage, a younger demographic, and no lingering scars from the Great Financial Crisis. The rate hikes in 2022 were driven by soaring core inflation, and the Fed was struggling to maintain its credibility.
Presently, the situation has shifted, and the Fed faces the risk of making a substantial policy mistake. Interestingly, monetary policy is even tighter than it was in 2007. This predicament has raised concerns, and there’s an awareness within the Fed of these risks. To shed light on this, a 2017 speech by former ECB President Mario Draghi is referenced. Back then, despite ECB rates being at -0.40%, European nominal growth was strong, contrasting today’s economic conditions.
In this context, the hypothetical statement for Fed Chair Powell suggests that if the economy weakens while maintaining a constant policy stance, the central bank may need to cut rates to prevent further restriction. The key message is that keeping the Fed Funds rate at 5.25% for too long while economic growth is below trend and core inflation shows signs of slowing down to or below 2% could be a perilous and irrational policy mix. It hints at the likelihood of future Fed rate cuts, which the markets seem to favor, as long as they are not deemed emergency measures.