Fed signals caution on lowering interest rates

The U.S. Federal Reserve has a highly unenviable task — to drive inflation back down to its target rate of just 2%. Needless to say, that task has been a daunting challenge. In June 2022, inflation had soared to a 42-year high of 9%. To the Fed's credit, by June 2023, inflation had declined to 3.1%. Since then, however, that downward trajectory has hit a brick wall. Over the past nine months, the average reported inflation rate has been 3.3%. In March, inflation jumped from 3.2% to 3.5%, a six-month high.

As America's central bank, the Fed guides our nation's monetary policy. By manipulating the cost and availability of credit, the Fed seeks to influence spending, employment, investing — and inflation — to promote the health of our economy. One of its main tools in this endeavor is to adjust the benchmark fed funds rate, which serves as a basis for many types of consumer and business debt. As the fed funds rate is raised or lowered, so typically do interest rates on credit cards, bank loans, auto loans, HELOCs and even home mortgages.

Between March 2022 and July 2023, the Fed raised the fed funds rate from near-0% to a level between 5.025%-5.5%, where it currently stands. This was the most aggressive pace of interest rate hikes by the Fed in nearly 44 years. The Fed hopes that by raising interest rates it will help reduce spending by making it more expensive for consumers and businesses to buy goods and services on credit. As spending falls, inflationary pressures should likely ease.

In January, there was hope the Fed would soon be able to start lowering interest rates. The Fed had publicly forecast three 0.25% reductions to the fed funds rate during 2024. Wall Street was even more optimistic, projecting the Fed would implement as many as six 0.25% reductions this year.

But as the weeks and months have ticked away, that optimism has quickly faded. As more and more economic data is released, the more it indicates this inflation problem is not likely to go away any time soon. Equally important, it calls into question the Fed's ability to start lowering interest rates.

On Tuesday, that concern was reinforced by Fed Chair Jerome Powell. In his comments, Powell addressed the lack of progress in inflation returning to 2% and the Fed's forecast to begin lowering interest rates in 2024. Powell admits the Fed "will need greater confidence that inflation is moving sustainably toward 2% before it would be appropriate to ease policy." He further stated, "the recent data have clearly not given us greater confidence and instead indicate it is likely to take longer than expected to achieve that confidence." In other words, because inflation has remained stubbornly high, there's no guarantee the Fed will be able to start lowering interest rates in 2024. But why are Powell's comments so important?

The American economy has been struggling with high interest rates for more than two years. As a result, interest rates on many forms of consumer and business debt have soared. According to LendingTree, the average interest rate on new credit cards is 24.7%, a near-record high. Bankrate reports the average interest rate on a new 30-year home mortgage is 7.22%. Late last year, mortgage rates breached the 8% mark for the first time since 2000.

The Fed understands that lowering interest rates would provide much-welcomed financial relief to consumers and businesses. But the Fed is also aware that if it prematurely begins to lower interest rates, it risks reigniting inflation even higher. The U.S. economy suffered such a fate in the mid-1970s and early 1980s.

By November 1974, inflation had reached 12.2%. Two years later, in December 1976, inflation had fallen to 5%. But the Fed prematurely assumed that inflation would continue its downward trajectory. As part of that critical mistake, the Fed started lowering interest rates before inflation was fully tamed. In early 1977, inflation started to rise again. By March 1980, inflation had surged to 14.6%.

As history has shown, the Fed learned a painful lesson by lowering interest rates too soon. That lesson is one the Fed wants to avoid repeating.