Federal Reserve chief should go fly-fishing and leave interest rates alone

Economic news has been good lately. Gross domestic product grew 3.3% in the fourth quarter, and inflation has come down. The Federal Reserve has signaled it may start cutting interest rates later this year, but perhaps it should just leave them alone — indefinitely.

For one thing, it would conserve some space to lower rates should the economy start heading into a recession.

Granted, economists expect slower growth this year, but early in 2003, they were issuing similar warnings. The economy keeps chugging along at a remarkable pace, and we may not be done with inflation just yet.

During the COVID-19 lockdowns, federal assistance to households was more generous than needed, consumers piled up extra savings that they spent as the economy reopened, inflation jumped, and the Fed raised interest rates.

Demand has been weak in Europe as those economies adjust to the transition to electric vehicles and green energy and wean themselves from Russian natural gas. China is reeling from a property-debt bubble, weakening consumer demand there too.

Together, these have given us lower gasoline prices since June and a stronger dollar against the yuan, which holds down prices for nonfuel imports.

Labor markets remain reasonably tight — job openings exceed job-seekers 1.4-to-1 — when a ratio below 1 is likely needed to neutralize inflation. This is especially true in the services sector, where wage pressures are most felt.

The Fed prefers to focus on the personal consumption expenditures deflator from the GDP accounts to the consumer price index. The former is mostly compiled from the same Bureau of Labor Statistics surveys as the CPI but includes items households don’t pay for directly — for example, medical expenditures paid through employer contributions to health insurance and Medicare.

Last year, the PCE deflator rose only 3.7%: For goods, it was 1.2% and for services 5.1%. The monthly change for December was 2% on an annualized basis, falling for goods but rising by 4.2% for services.

These indicate the Federal Reserve should stay the course and avoid a premature celebration of the end of excessive inflation. The history of 100 episodes across 40 countries, as compiled by the International Monetary Fund, indicates that when central banks refrain from cutting interest rates too quickly on good news, longer-term growth performance is better.

For another thing, interest rates at their current level may benefit the economy if it continues to expand.

Considerable attention is focused on the bank overnight borrow rate or federal funds rate, which the Fed sets, but our focus should be on the 10-year Treasury rate, which provides a benchmark for mortgage rates, car loans, corporate bonds and other business borrowing.

Currently, that rate is about 4%.

That 10-year Treasury was low by historic standards from just after the global financial crisis of 2007-2009 to COVID-19. From 2008 to 2023, it averaged only 2.5%. Adjusting for inflation, the real 10-year rate averaged only 0.3%.

As we advance larger federal deficits and investments to mitigate climate change, building out green energy and the investments needed to develop and apply artificial intelligence will boost demand for longer-term borrowing.

For example, earlier in this century, internet companies such as Alphabet did not require large amounts of seed capital. Google’s initial capitalization was $25 million. In contrast, Microsoft’s initial investment in Open AI was $1 billion.

A good benchmark for the long-term rate of interest in a healthy economy is the sustainable rate of inflation plus the trend rate of growth, which the Fed and macroeconomists generally peg at 1.8%, plus inflation.

AI should boost productivity and growth a bit.

If the inflation is sustainable at 2% as the Fed targets, then a 10-year Treasury at 4% is just about right. If attainable inflation runs a bit higher — for example, 3% — then a benchmark Treasury rate at 5% is about right.

Fed policy prominently affects the economy through the housing market.

The 10-year Treasury rate jumped to nearly 5% last October, and mortgage rates soared. Since it has fallen closer to 4%, mortgage rates have fallen, and home prices have risen. The housing market does not need more support.

Investments in artificial intelligence and elsewhere in the economy are reasonably robust. As noted, the labor market hardly needs more encouragement.

The Fed has two principal levers — as noted, federal funds rate and adding and influencing the demand for credit by purchasing and selling Treasury and mortgage-backed securities. Since March, it has been selling securities, and that has helped support the 10-year Treasury rate.

Over the 40 years before the financial crisis, the nominal and real 10-year Treasury rates averaged 7.4% and 3.4%, respectively. The economy did reasonably well, and the S&P 500 returned 10.5% per year against an average inflation of 4%.

Leaving the 10-year Treasury rate around 4% hardly seems restrictive.

Perhaps Federal Reserve Chairman Jerome Powell should take his policymaking committee fly-fishing and leave the economy alone.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.